Module 1- Introduction to Foreign Exchange

Learning Objective:
After studying this module, students will be able to:
● Know the Concepts in Foreign Exchange
● Understand Why we need FE
● Understand how does Foreign Exchange work in global trade
● Know Market stats of FE

Structure:
1.1 Foreign Exchange concepts
1.2 Why do we need Foreign Exchange?
1.3 How does Foreign Exchange work in global trade
1.4 Market stats of Foreign Exchange
1.5 Summary
1.6 References

1.1 Foreign Exchange Concepts

The act of converting one currency into another at a predetermined rate known as the foreign
exchange rate is known as foreign exchange (Forex or FX). The market dynamics of supply
and demand determine the fluctuating exchange rates for practically all currencies.
The US dollar, the Euro, the Japanese yen, the British pound, and the Australian dollar are the
world's most commonly traded currencies. The US dollar continues to be the dominant
currency, making up more than 87% of all daily trades.

Factors that Affect Foreign Exchange Rates

The market forces that determine foreign currency rates may be influenced by a variety of
factors. Numerous economic, political, and even psychological issues are among them. Trade
balances, inflation, and the outlook for economic growth are some of the economic factors.
Political events, such as political instability and political wars, can weaken the value of a
currency, therefore they have a big impact on the FX rate as well. Exchange rates can also be
impacted by players' mentality on the forex market.
The Foreign Exchange Market

All currency exchange trades take place in the foreign exchange market, a decentralised over-
the-counter marketplace. It is the biggest and most liquid market in the world (in terms of trade
volume). According to the Bank of International Settlements' Triennial Central Bank Survey,
the average daily amount of FX market transactions is $5.1 trillion (2016).

The largest trading centres for the forex market are situated in well-known financial capitals
throughout the globe, such as New York, London, Frankfurt, Tokyo, Hong Kong, and Sydney.
As a result, foreign exchange transactions are carried out every day of the week, around-the-
clock (except weekends).

Despite the fact that forex markets are decentralised, participants all receive the same exchange
rates because doing otherwise could result in arbitrage opportunities.

One of the most accessible financial markets is certainly the foreign exchange market.
Tourists, novice traders, huge financial institutions (including central banks), and
multinational enterprises all participate in markets.

Additionally, there is more to the forex market than just the straightforward exchange of one
currency for another. A wide range of financial instruments, such as futures, swaps, options,
etc., are frequently used in major market transactions.

Need for Conversion

Any nation, developed or developing, must reach outside of its borders and restrictions to
engage in trade. Each nation's currency is only accepted as legal tender inside its own borders.

Second, there isn't a single global currency that can be used to settle commerce between
nations. The payment must be made in a third currency that both parties agree to accept or in
the currency of either the buyer or the seller. This demands the exchange of one money for
another.
Exchange Control

The need for foreign currency stems from the need to send money abroad to pay for imports,
loan repayments, and personal needs like travel and education.

The sources of supply for foreign exchange include export revenues, remittances from non-
resident Indians, loans obtained from external funding organisations, etc.

The demand for foreign currency in our nation, India, considerably outweighs the supply
(inflow of foreign currency). Therefore, foreign currency is a valuable resource that can be
used for a variety of purposes. The Reserve Bank of India oversees the use of this precious
resource on behalf of the Government of India in order to protect it and ensure its wise use.

In other words, under the Foreign Exchange Management Act, the RBI is required to control
foreign exchange, and this control is referred to as Exchange Control.

Trade Control

International trade is the movement of goods that causes currency fluctuation. While the
government of India exercises exchange control over the movement of currency, trade control
is used to refer to control over the movement of products.

Role of RBI and Banks

RBI oversees the exchange market in India and has given banks authority to conduct the real
exchange activity.

The RBI has given the Foreign Exchange Dealers' Association of India the authority to set the
rules for conducting exchange business in order to ensure that everyone doing exchange
business adheres to the same standards and processes.

Foreign Exchange Transactions

Foreign exchange transactions are actions that result in the conversion of one currency into
another. It is simpler to spot a foreign exchange transaction if you (a) look at it from the bank's
(market's) perspective and (b) ask what happens to the foreign currency in question.

Settlement of foreign exchange transactions: (Nostro, Vostro and Loro accounts)

Any bank that purchases a foreign currency check or export bill for USD 10,000 sends the
instruments and documentation to the overseas correspondent for collection. The foreign
correspondent credits the funds to an account the bank keeps with the correspondent after
realising the transaction.

Similar to this, when a bank sends a draft for USD 5000 to a foreign correspondent, the drawee
bank honours the draught by debiting the sending bank's account.

The bank's NOSTRO account is the one it maintains with its foreign correspondent. For the
purpose of settling their rupee transactions, foreign correspondents also maintain rupee
accounts with Indian banks. These accounts are known by the Indian banks as VOSTRO
accounts.

As a result, transactions involving foreign exchange are paid by entries made to certain foreign
centres' bank accounts. Funds are not physically moved from one centre or bank to another.

Simply said, Vostro accounts are local currency accounts (for example, in Indian Rupees) kept
by international banks and Nostro accounts are foreign currency bank accounts maintained by
banks in specific overseas locations (say in India)

similar to how one bank may hold a nostro account with another. Another bank might continue
to keep its nostro account with the same foreign institution. This account may be referred to as
a "Loro account" by the first bank.

Types of foreign exchange transactions:

Although purchases and sales of foreign currency can be generically classified as transactions,
not all purchases and sales are the same.
Purchases:

The transaction is known as a TT purchase transaction when we buy DDs, MTs, or TTs, among
other securities, where the proceeds have already been credited to the Nostro Account.

Bill buying transactions include the acquisition of checks, export bills, etc. where foreign
currency will be credited to the nostro account only upon realisation. Transactions with a time
lag between the date of purchase and the date of credit to the nostro account are referred to as
bill purchasing transactions.

Sales:

Clean instrument issuance for non-import reasons, such as DD, MT, and TT issuance, is
categorised as a TT sales transaction.
Bill selling transactions are sales made to settle import bills.

Exchange Rate:

The exchange rate is the price at which one currency is transformed into another. It displays
the value of one currency relative to another.

Rates might be either fixed or variable. If it needed fixing, a country's central government
would typically do it. If floating, market forces and players make the decision.

Method of quoting rates:

There are two ways to quote exchange rates: directly or indirectly.

In the direct quote, the local currency equivalent is moving (say, the Indian Rupee) but the
foreign currency component is stable (1 USD = 54 INR). The indirect quote will work in
reverse, with the local currency (in this case, the Indian Rupee) being constant and the foreign
currency (in this case, the US Dollar) fluctuating, as in 100 INR = 1.8519 USD.
Foreign Exchange Markets

Foreign exchange likewise has an active worldwide market, just like any other commodity. The
market is divided into the following three segments:

● Merchant market: All banks, as well as their export-import clients and other
businesses, make up the merchant market. Banks buy currency from their exporter
clients and sell it to their importer clients to satisfy their needs.

● Interbank Market: Constituted by banks alone.

● International / Overseas Market: Consists of all banks participating in the foreign

currency market on a global scale.

1.2 Why do we need Foreign Exchange?

In the world we live in today, products and services are traded for money. This cash comes in
the shape of a certain currency. The demand for foreign exchange arises because the value of
one currency will differ from that of another. Because of this, worldwide investments and trade
depend on foreign currency. Without it, it would be extremely difficult to estimate the worth
of the commodities and services that various nations import from and export to one another.
Companies that depend on foreign resources and skills would be totally crippled without the
ability to trade. Foreign exchange is crucial since it would be extremely difficult for foreign
tourists to buy or sell anything while abroad.

The forces of supply and demand in the market determine how much a currency will change.
Additionally, they vary according to how people around the world feel about a specific nation
and its currency. This implies that rates are subject to change at any time.

It would be simpler to exchange different currencies for one another if there were a foreign
exchange market to establish the value of each foreign currency. Overall, the world and the
many diverse countries and economies here are able to run well on a daily basis thanks to
foreign money and the foreign exchange market. Modern trade and business would not be
feasible at all without the use of foreign money.
1.3 How does Foreign Exchange work in global trade

Foreign exchange market (also known as the FX market or fx market): institution for
exchanging one country's currency for another. Due to the fact that trading between different
currencies, such as the euro and the dollar, each represents a market, foreign exchange markets
are actually made up of many different markets. The earliest and oldest financial markets are
the foreign exchange markets, which continue to serve as the foundation upon which the rest
of the financial system is built and traded. Foreign currency markets offer global liquidity,
ideally with some degree of relative stability.

A foreign exchange market is an over-the-counter (OTC) and dealers' market that operates
around-the-clock. Transactions are carried out via telecommunications between two
participants. The spot markets, used for two-day settlements, and the forward, swap, interbank
futures, and options markets are additional divisions of the currency markets. Trading in
foreign exchange is dominated by London, New York, and Tokyo. The foreign exchange
markets are the biggest and most liquid of all the financial markets, with daily global turnover
in the trillions of dollars, according to the Bank for International Settlements' (BIS) triennial
statistics.

Such an indicator of financial activity could be inflated due to the widespread use of hedging
and exchanging into vehicle currency as a more liquid medium of exchange, but in the early
21st century foreign exchange The annual amount of the currency market is traded every five
days.
The need for foreign currency for merchants to conclude transactions led to the initial rise in
demand for foreign exchange. Today, however, foreign exchange is bought and sold for risk
management (hedging), arbitrage, and speculative gain, in addition to commercial trading and
investment requirements.

Therefore, rather than trade flows, financial flows are the main driver of exchange rates; for
instance, interest rate differentials attract money that is motivated by yield. As a result, many
people believe that the currency markets serve as a continuing, permanent referendum on
governmental policy and the state of the economy; if the markets are unimpressed, they will
leave a currency. However, arguments over whether exchange rate changes are better classified
as rational, "overshooting," or speculatively irrational, as well as those over the real versus
potential mobility of capital, continue to be in contention.

A classic autonomy problem is illustrated by the escalating asymmetry between national

governments and the currency markets. The Mundell-Fleming model outlines the "trilemma"
of economic policy alternatives open to governments. The model demonstrates that
governments must select two of the three following policy objectives:

(1) the freedom to set interest rates and manage the money supply domestically, which allows
one to restrain growth.

(2) stability of exchange rates (the capacity to lower uncertainty through a fixed, pegged, or
controlled system); and

(3). Capital movement (allowing investment to move in and out of the country).

In the past, many international monetary regimes have prioritised various policy combinations.
For instance, the Bretton Woods system placed more emphasis on the first two than on
unrestricted capital flow. The stability and predictability of the currency markets were
destroyed by the system's collapse. Large volatility that followed led to an increase in exchange
rate risk (as well as in profit opportunities). The transition to floating exchange rates, the
political liberalisation of capital controls, and technical and financial innovation are only a few
of the various challenges that governments today face. These issues are frequently grouped
under the term’s "globalisation" or "capital mobility."

Floating exchange rates are typical in the modern global monetary system. However, some
governments pursue various alternative policy combinations or make attempts to reduce
exchange rate swings using various tactics. The Plaza Agreement in 1985 and the Louvre
Accord in 1987, for instance, showed the United States' desire for ad hoc international
cooperation to intervene and control the value of the dollar. While many developing nations
with smaller economies chose the path of "dollarization," that is, either fixing to or choosing
to have the dollar as their currency, Europe responded by moving forward with a continental
monetary union in an effort to remove exchange rate risk.
As evidence of the significant role that private organisations, including credit rating agencies,
play in directing the markets, the international governance regime is a complex and
multilayered bricolage of institutions. In addition, banks continue to dominate the market and
are under the control of national monetary authorities. The Basel Committee on Banking
Supervision, a unit of the BIS, issued the international regulations that these national monetary
agencies abide by. To safeguard principals from credit risk, market risk, and settlement risk,
capital adequacy criteria must be met. Importantly, risk management has mostly evolved into
a topic for internal setup and monitoring, at least among the top multinational banks.
The string of contagious currency crises that occurred in the 1990s in Mexico, Brazil, East
Asia, and Argentina brought the issues with the global monetary system back into the forefront
of policymakers' consideration. There have been, albeit modest, steps taken in the direction of
a new global financial architecture. The Financial Stability Forum (now the Financial Stability
Board), which looked into issues with offshore, capital flows, and hedge funds, and the G20,
which aimed to increase the legitimacy of the global regime by diversifying its membership,
were two of the most significant outcomes of these crises. In addition, some civil society non
governmental groups as well as some governments advocated for a currency transaction tax,
which was named after the idea of Nobel Laureate James Tobin. For governments and their
independence, businesses and the stability of their investments, and individuals who, in the
end, are those who absorb these impacts as they are transferred into everyday life, the success
of international monetary reform is a critical problem.

1.4 Market stats of Foreign Exchange

In 2022, the size of the global foreign exchange market was $753,2 billion. Looking ahead, it
is expected that the market will increase at a 7% compound annual growth rate (CAGR) from
2023 to 2028, reaching US$ 1,143.2 billion.
Market Segmentation

Breakup by Counterparty:

● Reporting Dealers
● Other Financial Institutions
● Non-financial Customers

Because they actively do business with significant clients like big corporations and financial
institutions, reporting dealers dominate the industry.
Breakup by Type:

● Currency Swap
● Outright Forward and FX Swaps
● FX Options

Due to its ability to help businesses get loans in foreign currencies at lower interest rates,
currency swap now has the biggest market share.

Breakup by Region:

● North America
● Asia Pacific
● Europe
● Latin America
● Middle East and Africa
Due to improved trade monitoring and surveillance in the forex market across the area, North
America currently holds the top spot in the industry.

1.5 Summary

● The act of converting one currency into another at a predetermined rate known as the
foreign exchange rate is known as foreign exchange (Forex or FX).
● All currency exchange trades take place in the foreign exchange market, a decentralised
over-the-counter marketplace.

● The exchange rate is the price at which one currency is transformed into another. It
displays the value of one currency relative to another.
● The forces of supply and demand in the market determine how much a currency will
change.
● A foreign exchange market is an over-the-counter (OTC) and dealers' market that
operates around-the-clock.

● Because they actively do business with significant clients like big corporations and
financial institutions, reporting dealers dominate the industry.

1.6 References

Foreign Exchange -Basics: Theory – JK SHAH

Foreign Exchange - RBI

 Module 2 - Estimating and Forecasting FE

Learning Objective:

After studying this module, students will be able to:

● Know the drivers of exchange rates
● Understand Global currency codes and conversions
● Understand buying and selling/Trading with FE
● Know Direct /Indirect Quotes and Cross Rates

Structure:

2.1 Drivers of exchange rates

2.2 Global currency codes and conversions
2.3 Buying and selling/Trading with FE
2.4 Direct /Indirect Quotes and Cross Rates
2.5 Summary
2.6 References

2.1 Drivers of exchange rates

● Inflation Rates

Currency exchange rates fluctuate as a result of changes in inflation. In general, a nation whose
inflation rate is relatively lower will experience an increase in the value of its currency. When
inflation is low, prices for goods and services rise more slowly. Countries with consistently
low inflation show rising currency values, while those with higher inflation frequently see
currency depreciation, which is commonly accompanied by rising interest rates.

● Interest Rates

There is a correlation between interest rates, inflation, and currency rates. By changing interest
rates, central banks can affect both inflation and currency rates. Compared to other nations,
higher interest rates provide lenders with a better return. Any increase in a country's interest
rate results in an increase in the value of its currency since higher interest rates translate into
higher rates for lenders, drawing in more foreign money and driving up exchange rates.

● Recession

If a nation experiences a recession, its interest rates will be reduced, making it more difficult
for it to raise foreign funds. As a result, its currency depreciates in value against those of other
nations, which lowers the exchange rate.

● Current Account/Balance of Payments

The balance of commerce and income from foreign investments are both reflected in a country's
current account. It includes all transactions, including debt, imports, and both exports and
imports. Its current account is in deficit because it spends more of its currency on importing
goods than on exporting them. As a result, the country's currency rate is lowered to the point
that domestic goods and services are less expensive than imports, leading to domestic sales as
well as exports as the prices of the goods fall on global markets.

● Terms of Trade

The ratio between export and import prices is known as the terms of trade. A country's terms
of trade will have improved if the price of its exports rises faster than the price of its imports.
A country's exports are more in demand when terms of trade are rising. The increase in export
earnings that follows has the effect of rising currency demand and driving up the value of the
nation's currency. The value of the currency will fall in comparison to that of its trade partners
if the price of exports increases at a slower rate than the price of imports.

● Government Debt

Government debt is any debt that the federal or state governments own. Large government
deficits and debt make a country less appealing to international investors and reduce its
likelihood of attracting foreign money, which can cause inflation. Foreign investors will predict
an increase in government debt in a specific nation. The value of this nation's exchange rate
will consequently decline.

● Political Performance and Stability

The strength of a nation's currency can vary depending on its political climate and economic
health. Investment flows away from other nations that are thought to have greater political and
economic risk toward those with lower risk of political turmoil. The value of a nation's currency
rises when foreign investment increases, while depreciation is more likely to occur in nations
where political unrest is a problem.

2.2 Global currency codes and conversions

The three-letter alphabetic codes known as ISO currency codes stand in for the various
international currencies. They make up the symbols and cross rates used in currency trading
when paired in pairs.

There is a three-digit numeric code that corresponds to each of the country-specific three-letter
alphabetic codes. The International Organization for Standardization (ISO), a voluntary
organisation that develops standards for business, technology, and communication, has
identified these codes. The guiding document for currencies is known as ISO 4217:2015.
Currency pairs, which are the quotation and price structures of the currencies traded in the forex
market, are fundamentally based on ISO currency codes. A currency's rate, which is decided
by comparison to another currency, represents its value.

The base currency and quote currency are the first and second three-digit codes used to identify
the currencies in a currency pair quotation, respectively. The exchange rate between the two
currencies shows how much of the quote currency is required to buy one unit of the base
currency.

The euro's quote against the dollar, for instance, is EUR/USD. The three-letter ISO currency
codes for the U.S. dollar are USD and EUR, respectively, for the euro.
One euro is exchanged for 1.2500 U.S. dollars at the quoted price for this pair since EUR is the
base currency and USD is the quoted currency (or counter currency). As a result, 1 euro can be
converted into 1.25 USD. To put it another way, it will cost you USD $125 to purchase EUR
100.

It wasn't until 1973 that ISO concluded that it would be beneficial to get involved in money
transactions. The first standardised currency codes with a standard for how they should change
were issued in 1978 after five years of collaboration and discussion.

The Euro and the US Dollar are the most widely used foreign currencies worldwide. Other
significant trading currencies include:

● Japanese Yen (JPY),

● British Pound Sterling (GBP),
● Australian Dollar (AUD),
● Canadian Dollar (CAD),
● Swiss Franc (CHF),
● Chinese Yuan (Renminbi; CNY),
● Swedish Krona (SEK),
● New Zealand Dollar (NZD), and
● Mexican Peso (MXN).

2.3 Buying and selling/Trading with Foreign exchange

The exchange of the currencies of the trading nations facilitates numerous worldwide
exchanges of products and services. In order to pay for the items to be imported, importers
frequently need access to the exporter's nation's currency. They must determine a relative value
between currencies even when they don't require the actual currency. This is a challenging task
given the variety of nations, currencies, and economic links throughout the world. The process
for determining the relative prices of currencies is the international monetary system. The
combination of supply and demand in these global currency markets determines the actual price
(or international value) of currencies. The supply and demand for a certain currency can be
influenced by a variety of factors, just like in any market, and this will have an impact on the
currency's exchange rate internationally.

Most of the world's currencies have a daily value, or exchange rate, that is set by the Forex
market. The amount of euros received when converting dollars to euros at a bank or exchange
kiosk will depend on the current exchange rate. If the price of imported French cheese increases
overnight at the supermarket, it's possible that the euro has gained value in forex trading as
compared to the US dollar.

Forex traders aim to make money off of the ongoing changes in currency values. For instance,
a trader may believe that the value of the British pound will increase. The merchant will convert
dollars into pounds sterling. In the event that the pound gains strength, the trader may reverse
the deal and receive additional dollars in exchange for the pound.

Currency Pairs

Currency pairs, such as USD/CAD, EUR/USD, or USD/JPY, are listed in forex trading. These
show the exchange rates between the US dollar (USD) and the Canadian dollar (CAD), the
euro (EUR) and the USD, and the US dollar (USD) and the Japanese yen (JPY) (JPY).

Each pair will also have a price, such as 1.2669, attached to it. If this is the USD/CAD pair,
one USD is equivalent to 1.2569 CAD. If the price rises to 1.3336, one USD will now cost
1.3336 CAD. CAD currently costs more to buy one USD due to the USD's rising value in
relation to CAD.
Currency exchange in the forex market takes place in lots known as micro, mini, and normal
lots. A micro lot is $1,000, a mini lot is $10,000, and a standard lot is $100,000 worth of a
particular currency. Trades are conducted in predetermined blocks of money. For instance, a
trader can trade 75 ordinary lots, three mini lots, or seven micro lots (each worth 7,000).
(7,500,000).

In general, the currency market has a huge trading volume. The average daily value of trading
on the foreign exchange markets in April 2019 was $6.6 trillion, according to the Bank for
International Settlements.
Trading in the Foreign Exchange Market

Everywhere in the world, the Forex market is open twenty-four hours a day, seven days a week.

In the past, only governmental entities, major corporations, and hedge funds participated in the
foreign exchange market. Trading currencies is now as simple as clicking a mouse, and
accessibility is not a problem. People can open accounts and exchange currencies on the
platforms of several investing firms.

This is not the same as going to a kiosk to exchange money. There is no actual handing over
of money; the process is totally computerised. Instead, traders are assuming a stake in a certain
currency in the hopes that there will be some strength and upward movement in the currency
that they are buying, allowing them to benefit.

Example of a Forex Trade

As the economy of the Eurozone weakens, a trader believes that the European Central Bank
(ECB) would loosen its monetary policy in the upcoming months. As a result, the trader makes
a wager that the euro will lose value relative to the dollar and sells €100,000 worth of currency
short at a rate of 1.15. The ECB sends forth signs that it may certainly loosen monetary policy
during the coming weeks. As a result, the euro's value relative to the dollar dropped to 1.10 at
that time. The trader makes a $5,000 profit as a result.

The trader earned $115,000 for the short sell by shorting €100,000. It only cost the trader
$110,000 to buy the euro again once the currency plummeted and the dealer covered the short.
The profit is the difference between the sum collected from the short sale and the purchase
made to make up the shortfall. It would have been a loss if the euro had risen against the dollar.

2.4 Direct /Indirect Quotes and Cross Rates

Direct Threat

One of the two ways to define or represent the foreign currency conversion rate with the local
currency is through a direct quote. As of February 27, 2020, it is stated how many units of
domestic currency, or Rs, are required to purchase one unit of foreign currency. To buy $1,
72.2725 /- is required.

There are two ways to express and show conversion rates for foreign currencies: direct
quotations or indirect quotations. In the indirect quotation approach, the domestic currency
amount varies based on the location of the transaction while the foreign currency amount is
fixed.

The direct method typically specifies the amount of local currency needed for conversion into
the desired foreign currency, making it clear and simple for the consumer to understand.
Therefore, if the rate of conversion is lower, it indicates that the market value of the local
currency is rising. In contrast, a higher conversion rate indicates that the market value of a
domestic currency is declining.

Formula

The amount of local money required to convert one unit of foreign currency will be the
outcome. If the indirect quote is available, for instance, the formula below could be used:
Where indirect quote will be given as the amount of foreign currency required for the 1 unit of
the domestic currency.
Direct Quote Example

An Indian company named ABC Ltd. needed $1200 and was told that in order to do so, it would
need to convert INR 84000. Comment on the company's direct quote.

Solution: The straight quote will be in the form of "Domestic Currency (i.e., INR) needed for
conversion of 1 unit of Foreign Currency" because ABC Ltd. is an Indian corporation and has
its headquarters there (i.e., USD).

So, as per the formula, the quote would be;

= Domestic Currency (INR) / Foreign Currency (USD)

= 84000 / 1200
= 70
So, this would be; INR 70 per USD at the time of conversion.

How is it Used?

Direct quotations are sometimes the most popular technique to convey or present the rate of
currency exchange. However, this technique is most frequently used when the market value of
the base currency exceeds that of the counter currency.

Let's look at an illustration to better grasp this idea. At one point, 72 units of the Indian rupee
(INR) were required to buy one US dollar.
As the foreign currency (USD) is of the fixed unit with the changeable domestic currency, the
statement will be interpreted as a direct quote in this instance (INR). In this case, the USD base
currency has a higher market value than the INR counter currency.

Indirect Quote

In the foreign exchange market, a currency quotation known as an "indirect quote" indicates
the variable amount of foreign money needed to purchase or sell one unit of the local currency.
Since it expresses the amount of foreign currency needed to purchase units of the domestic
currency, an indirect quote is often referred to as a "quantity quotation." In an indirect quote,
the local currency serves as the base currency and the foreign currency as the counter currency.

A direct quote, commonly referred to as a "price quotation," expresses the cost of one unit of a
foreign currency in terms of a variable number of units of the domestic currency. An indirect
quote is the reverse, or reciprocal, of a direct quote. Since the U.S. dollar (USD) dominates the
world's foreign exchange markets, it is customary to utilise direct quotes in which the dollar
serves as the base currency and other currencies, such as the Canadian dollar (CAD), Japanese
yen (JPY), and Indian rupee (INR), serve as the counter currency. The euro and Commonwealth
currencies, such as the British pound (GBP), Australian dollar (AUD), and New Zealand dollar
(NZD), which are frequently quoted in indirect form (for instance, GBP 1 = USD 1.30), are
exceptions to this rule.

Take the Canadian currency, for instance, which we'll say is currently trading at 1.2500 to the
US dollar. The indirect equivalent of this statement in Canadian currency is C$1 = US$0.8000
(i.e. 1/1.2500). The standard exchange rate, however, is 1.2500, which is an indirect quote from
the standpoint of the United States because it indicates how much of a foreign currency (CAD)
is needed to obtain 1 USD. In contrast, a direct quote would be USD 0.8000. A lower exchange
rate suggests that the domestic currency is weakening or degrading in an indirect sense. In
keeping with the previous example, if the USD/CAD quotation now reads US$1 = C$1.2300
(indirect quote), it indicates that the US dollar has lost value because less CAD is required to
buy one US dollar. The straight quote, which is 0.8130 (1/1.2300), demonstrates that, as
opposed to 0.8000, 1 CAD will buy you 0.8130 USD.

Cross Rates
A cross rate is a quote made on the foreign exchange market between two currencies, one of
which is not the U.S. dollar, and the other two are then valued in relation to one another. The
U.S. dollar is usually thought to assume the value of one when used as a base currency.

It is crucial to first be introduced to typical cross rate pairs in order to become comfortable with
the notion before learning how to calculate cross rates.

A cross-rate pairing is created when two currencies are being valued in comparison to one
another. A cross rate is then calculated by comparing the pair to a base currency, such as the
US dollar.

Some of the more popular cross rates not involving USD include the following:

EUR/JPY = Euro/Japanese Yen FX Cross Rate

EUR/GBP = Euro/UK Pound Sterling FX Cross Rate
AUD/NZD = Australian Dollar/New Zealand Dollar FX Cross Rate
EUR/SEK = Euro/Swedish Krona FX Cross Rate

Cross Rates: How Are They Calculated?

A cross rate, as was previously mentioned, is the result of the valuation of the exchange market
price made in two currencies into a third currency. Two transactions are being computed in this
process.

The first is the person who exchanges one particular currency (such as the euro, yen, pound,
etc.) for its equivalent value in dollars. After receiving U.S. dollars, another exchange takes
place when the dollars are exchanged for the second particular currency.

Although it could be difficult to understand on paper, we will use a thorough example to further
clarify the transaction.

In the first example, we will show how to calculate cross rates using two indirect quotations,
and in the second, we will show how to calculate cross rates using two direct quotations.
 1. Indirect Quotations

A currency quotation that indicates the amount of base currency required to purchase one unit
of the quoted currency is known as an indirect quotation. Cross rates are also computed using
it.

For instance, suppose we wish to get the cross rate of EUR/JPY and the two foreign exchange
pairings being used are USD/EUR and USD/JPY.

Finding the bid/offer valuation of the two exchange pairs in use is the first step. In this instance,
the bid/offer ranges from 1.2191 to 1.2193 for USD/EUR and from 109.744 to 109.756 for
USD/JPY. Accordingly, you may get 1.2191 EUR or 109.744 JPY for every USD.

The idea of the bid or offer is crucial. As previously indicated, the base currency is the US
dollar ($1), while the quoted currency is the non-domestic currency.

However, this idea is different when it comes to indirect and direct quotations. This is due to
the fact that two foreign currencies must still be calculated using a base currency.

Assuming that the base currency in this example is the Euro, we will calculate EUR/JPY or
Euro Yen. Since the EUR is the base currency in this scenario, it has to be included in the
denominator.

If the client where to sell JPY and buy EUR (offer side), the equation would be as follows:

But if the client where to buy JPY and sell EUR (bid side), the equation would differ slightly:
The philosophy of "buying low and selling high" guides bank operations. In light of this, the
bank anticipates the EUR/JPY cross rate to be between 90.01 - 90.03.

2. Direct Quotations

In a direct quotation, the amount of the quoted currency needed to purchase one unit of the
base currency is specified.

For instance, in order to perform computations, we will require two foreign exchange pairings
and each one's bid/offer valuation. This is similar to the last example.

In this instance, the cross rate of NZD/AUD will be calculated using NZD/USD (0.7253-
0.7256) and AUD/USD (0.7701-0.7719).

Since the NZD is the base currency in this situation, it has to be included in the numerator.

The computation would look like this if the client (bid side) where to buy AUD and sell NZD:

But if the client where to sell AUD and buy NZD (offer side), the calculation would change to:
The bank estimates that the NZD/AUD cross rate will be between 0.94 - 0.97 with these factors
in mind.

2.5 Summary

● Currency exchange rates fluctuate as a result of changes in inflation. In general, a nation

whose inflation rate is relatively lower will experience an increase in the value of its
currency.

● There is a correlation between interest rates, inflation, and currency rates. By changing
interest rates, central banks can affect both inflation and currency rates.

● If a nation experiences a recession, its interest rates will be reduced, making it more
difficult for it to raise foreign funds. As a result, its currency depreciates in value against
those of other nations, which lowers the exchange rate.

● The ratio between export and import prices is known as the terms of trade. A country's
terms of trade will have improved if the price of its exports rises faster than the price of
its imports.

● Government debt is any debt that the federal or state governments own. Large
government deficits and debt make a country less appealing to international investors
and reduce its likelihood of attracting foreign money, which can cause inflation.

● The three-letter alphabetic codes known as ISO currency codes stand in for the various
international currencies.

● The base currency and quote currency are the first and second three-digit codes used to
identify the currencies in a currency pair quotation, respectively.
 ● The exchange of the currencies of the trading nations facilitates numerous worldwide
exchanges of products and services.

2.6 References

INTERNATIONAL FINANCIAL MANAGEMENT THIRD EDITION- Geert Bekaert and

Robert Hodrick
 Module 3- Foreign Exchange Markets

Learning Objective:
After studying this module, students will be able to:
1. Know what Foreign Exchange Markets and Transactions means.
2. Understand the Direct, Indirect and Cross Rates
3. Understand the difference between Forward Exchange Rates versus Expected Future
Spot Rate
Structure
3.1 Foreign Exchange Markets and Transactions
3.2 Direct, Indirect and Cross Rates
3.3 Forward Exchange Rates versus Expected Future Spot Rate
3.4 Summary
3.5 References

3.1 Foreign Exchange Markets and Transactions

The foreign exchange market is the world's biggest financial market that determines the
exchange rates of currencies. Also known as the forex or currency market, it is a place where
different types of currencies are traded. This is an over-the-counter (OTC) market with no
central market to facilitate easy trading and establish standards.

It is made up of many markets and traded between individual currencies to provide

international liquidity. Large commercial banks located in financial centers trade foreign
currency deposits with each other in the foreign exchange market. The value of a base
currency is determined by comparing it to other currencies through trading.

The Foreign Exchange Market is the world's biggest and most liquid exchange market. The
total amount of cash transactions is open to any entity or country. It is an OTC exchange
market because there is no central currency. Foreign exchange, or currency exchange, is an
important aspect for businesses and people operating in an international context. Facilitate the
conversion of foreign currency to domestic currency and vice versa.

Countries must convert their foreign currency into their domestic currency for use in their
home country. States must deal one-on-one with all foreign entities. This means that all
imports from foreign countries must be paid in your home currency and all exports must be
paid in other currencies. However, it's not really possible as you have to keep track of the
many currency rates and associated payment issues. As a result, most countries choose a
common currency to conduct their transactions.

Facilitates
ease of
transactions

Facilitates Foreign
Establishments of
International Exchange
standards
Trading Market

Determination
of exchange
rates

Foreign Exchange Market Utility

How does the Forex Market work?

Compares a country's currency to a common currency for international transactions.

Transactions are conducted in this currency, which is the dominant currency economically.
As a result, the country has to trade in US dollars or other major currencies such as Euros,
Pounds and Japanese Yen.

A balance of payments account helps track a country's foreign trade. This account is credited
with foreign currency receivables while foreign currency payments are debited. A country
with a balance of payments deficit will have a weaker currency, other factors being constant
and vice versa. Therefore, when a country's balance of payments is in deficit, the demand for
foreign currency increases. As a result, the value against the home currency rises.

Trade and exchange currencies of different countries in pairs. As a result, one of the
currencies has a different value than the others. It determines the amount of currency one
country can buy from another based on supply and demand and vice versa currency market.

The main task is to establish this price relationship all over the world. This will improve
liquidity in all other financial markets
 ⮚ Important for overall stability.
⮚ Forex market type

There are various trading modes in the forex market, which are embodied as follows:

1. Spot Market

Transactions require prompt payment at prevailing exchange rates. Immediate currency

delivery or on-the-spot exchange is often required within 48 hours. A spot transaction is a
transaction in which exchange occurs two days after the contract date. Spot rate is the
effective exchange rate for spot transactions, and the spot market is the market for such
transactions. Traders face uncertainty when the price of a commodity increases or decreases
between actual execution and trading hours.

2. Futures Market

It includes trades that will be exchanged at a specific price on a specific date in the future. In
other words, the futures currency market involves entering into a contract today to buy or sell
foreign currency in the future forward rate

Similar to the spot rate, except the delivery happens much later. However, there may be
differences between spot rates and forward rates. The difference is the transfer margin or
swap point. In addition, traders are free to customize the delivery period. This exchange helps
exporters and importers avoid rate fluctuation problems by using related forward exchange
contracts.

3. Future Market

A futures contract is another version of a forward contract publicly traded on a futures

exchange. Like a forward contract, it includes a price and a future time to buy or sell an asset.
Unlike forward contracts, futures contracts have a fixed contract size and maturity date.
Futures can only be exchanged on organized exchanges and are traded competitively. Unlike
all players in the futures market, forward contracts do not require margin. Additionally,
traders must pay an initial margin to a collateral account for creating future positions.

4. Swap Market

Two streams of cash flow can be exchanged in two different currencies. A swap, or dual
trade, is an operation in which a purchase or sale of the same currency for transfer delivery is
followed by a simultaneous sale or buy of spot currency. Investors engaged in forwarding
exchange activities may use swap operations to change their fund positions.

5. Options Market

An option is a derivative product that allows a foreign exchange market operator to buy or
sell a foreign currency at a specified rate (strike price) before a certain date (maturity date).
call options. A trader can buy the underlying asset, while a put option allows the trader to sell
the underlying asset. Exercising an option means buying or selling the underlying asset
through the option. In the options market, it is not a trader's obligation to exercise an option.

Forex Market Graph

To illustrate how the forex market works, let's take his two currency examples, the US dollar
and the Chinese yuan. When market traders exchange dollars for Chinese yuan, the demand
for renminbi increases and so does the supply of dollars. To buy RMB from the market, there
must be an equal number of worthy dollars, thus increasing the supply of dollars. Demand
and supply factors work together. As people donate more and more dollars to buy renminbi,
the value of the dollar depreciates. The original value is appreciated due to the existing
demand for the currency. When your country's currency appreciates

1. Its import will be cheaper. When a currency depreciates

2. The import will be expensive. Countries now have to pay the value of their domestic
currency on par with any other currency to pay for goods.
Point of
Supply
Meeting

Price of Yuan

Demand

Quantity of Dollars
The graph shows that the equilibrium point (price and quantity) is where the RMB price
meets the dollar supply, also called foreign exchange rate.

Forex Market Participants

The structure of the forex market consists of various participants, some of which are:

1. International Company

International business enhances cash flow across the market. For example, a US-based
company sells tools in the UK. The transaction involves converting pounds to dollars for
repatriation. This makes them participants in the forex market.

2. Trader

Individuals who trade their money for profit are called traders. Retail traders occupy a sizable
and rapidly expanding sector of the market. These retailers serve customers looking to buy or
sell foreign currency for educational, travel, or tourism purposes.

3. Central Bank

These institutions have been contributing in the Forex market since the time of the history of
the Forex market. They control their country's money supply, interest rates and inflation to
stabilize the economy (e.g. US Central Bank – US Federal Reserve (Fed) and European
Central Bank (ECB)). Intervention from them reduces volatility in domestic currencies and
ensures that exchange rates are in line with the requirements of their economies. may decide
to sell. Increased foreign exchange supply will reduce demand and help halt the euro's
downtrend.

There are two methods of estimating exchange rates: direct estimating and indirect
estimating. A direct quote is the representation of one unit of a foreign currency in the local
currency. Similarly, an indirect citation is the representation of one unit of the local currency
in a foreign currency.

3.2 Direct, Indirect and Cross Rates

Direct and Indirect

Estimates are straightforward when the price of one unit of a foreign currency is expressed in
the domestic currency.

Estimates are indirect when the price of one unit of domestic currency is expressed in a
foreign currency.
Exchange rates are usually expressed against the United States Dollar (USD), as it is the most
dominant currency. However, exchange rates can also be quoted against currencies of other
countries, called cross-currencies.

Here, a declining exchange rate in the direct market means that the value of the domestic
currency is rising. On the other hand, the low indirect exchange rate indicates that the
domestic currency is depreciating as the foreign currency is less valuable.

Base Currency and Counter Currency

Now that we understand the concept of direct and indirect citations, let's look at other related
concepts. An exchange rate has two components: a base currency and a counter currency.

In direct quotes, the foreign currency is the base currency and the domestic currency is the
counter currency. In indirect citations, it's the other way around. The domestic currency is the
base and the foreign currency is the counter.

For example, USD to INR is a direct quote and INR to USD is an indirect quote. Most
exchange rates list the US dollar as the base currency. Exceptions in this case include the
Euro and Commonwealth currencies such as British Pounds (GBP), Australian Dollars
(AUD), and New Zealand Dollars (NZD).

Type of Exchange Rate

Floating and Fixed Exchange Rates

Exchange rates are not constant. They can be floating or fixed. An exchange rate is
considered floating if market conditions determine the currency rate. Most countries use
floating exchange rates. On the other hand, some countries prefer to peg their currency
against dominant currencies such as the US dollar.

Spot Exchange Rate

Exchange rates can also be categorized into two types: spot exchange rates and forward
exchange rates. A spot exchange rate is the current exchange rate at any point in time. A
forward exchange rate is an exchange rate that is displayed and traded as of today but is
expected to be paid and delivered at a future date.

What is a cross rate?

A cross rate is a forex market quote between two currencies (not including the US dollar),
both of which are valued against his third currency. When used as a base currency, the US
dollar is always assumed to assume a value of 1.

About Cross Rate Pairing

To understand how cross rates are calculated, we first need to familiarize ourselves with the
concept by touching on common cross rate pairings.

When two currencies are valued against each other, they are a cross-rate pairing. Pairings are
compared to a base currency (e.g. USD) to create a cross rate.

Some of the more popular cross rates that don't include the US dollar include:

EUR/JPY = Euro/Japanese Yen FX Cross Rate

EUR/GBP = Euro/British Pound FX Cross Rate

AUD/NZD = Australian Dollar/New Zealand Dollar FX Cross Rate

EUR/SEK = Euro/Swedish Krona FX Cross Rate

How is the cross rate calculated?

As mentioned earlier, the cross rate contains exchange market prices made in two currencies
and evaluated to a third currency. Two transactions are calculated during this process.

The first is an individual who trades one particular currency (EUR, JPY, GBP, etc.) with the
same equivalent amount in US dollars. Upon receiving the US dollar, once the US dollar has
been exchanged for his second specific currency, the exchange will take place again.

3.3 Forward Exchange Rates versus Expected Future Spot Rate

Forward Rate Meaning

Forward rate means the expected yield or interest rate on a future bond or foreign exchange
investment as well as a loan/debt. Investors must sign a contract agreeing to execute financial
transactions at a specified future date. Therefore, its calculation usually includes interest rate
and maturity.
This rate, also known as the forward yield, allows investors to choose from a variety of
investment options, such as US Treasury bills (T-bills), depending on the expected interest
rate. Two common methods of estimating future yields on investments are spot rates and
yield curves. Commonly used for hedging and acts as a financial market economic indicator.

Explanation of Forward Rate

The forward rate calculation takes interest rates into account observed for investments that
have reached maturity soon. Based on this analysis or forecast, traders decide whether future
returns on their investments are profitable. In addition, it is an economic indicator that helps
investors reduce currency market risk. As a result, investors prefer to invest in bonds or other
financial instruments only if you find a future yield worth those investments.

Includes forward rate agreements (FRA), derivative contracts Between two parties who agree
to complete the transaction at a later time. The contract becomes a legal obligation that the
parties must comply with in the forex market, even if futures yield forecasts are unsuccessful.
Futures yields also help determine the future value of bonds. Future dates can range from
months to the year.

FRAs are similar to futures contracts, but there are significant differences between the two.
Currency futures can be customized to the individual needs of the parties involved in the
transaction, whereas futures are not customizable and have a predetermined contract size and
expiration date.

Method

The standard formula used to calculate the forward rate is:

Forward rate = ((1+Ra)Ta/(1+Rb)Tb – 1)

where,

Ra = spot rate of a bond with maturity Ta

Ta = maturity of 1 term

Rb = spot rate for a bond with maturity Tb

Tb = maturity of second term

Calculation

Forward rates can be calculated using spot rates or the yield curve. The latter shows the
relationship between interest rates observed on government bonds of varying maturity. This
provides investors with insight into future interest rates that will drive the bond market. As a
result, we predict future yields and make investment decisions based on those predictions. On
the other hand, the former is the assumed yield of zero-coupon government bonds.

Suppose an investor wants to buy her 1-year bond. The two options available are to acquire a
1-year T-bill or invest in a 6-month T-bill and reinvest.

Do it for the next 6 months. Here, the investor can know the 6-month spot rate for her or the
1-year spot rate for him at the start of the investment. However, the forward yield, whose
exact amount is unknown, is the rate an investor would speculate on her second purchase of
her six-month Treasury bill.

Example

To understand the calculation, consider the following forward rate example.

Suppose Megan buys her 5-year bonds with an annual interest rate of 8% and her 3-year
bonds with an annual interest rate of 6%. She uses a futures rate formula to estimate future
values she decides whether to invest in.

Forward rate = ((1+Ra)Ta/(1+Rb)Tb – 1) = ((1+0.08)5/(1+0.06)3 – 1)

= 0.233692695

= 23.37%

Forward Rate and Spot Rate

The forward yield is the interest rate that will be paid on the bond in the future. Spot rate, on
the other hand, is the interest rate for future contracts that must be settled and delivered
immediately (on the spot) or on the same day. Settlement of a transaction involves payment,
while delivery involves transfer of title.

Although the two terms have different definitions, they are related to each other in multiple
ways. An investment's spot rate is essential for calculating futures yields
Distinguish between the Forward Rate and Spot Rate are:

Forward Rate Spot Rate

Future yield or rate of interest The current rate of interest or yield

Meant for investments made for a future date Meant for investments to be settled
immediately on the spot

Not applicable before a predetermined future Applicable for investments to be delivered

date is reached on the same day

Meaning

A spot rate is the value of an asset such as a commodity, the interest rate, or the exchange rate
of a currency in a transaction associating immediate delivery and payment.

Spot Rate Definition and Examples

A spot rate is a price at which an asset can be exchanged immediately. Like all prices, spot
rates are determined by supply and demand for that particular asset. An example of a spot
rate is the amount you currently pay to purchase a product, rather than a forward rate.

How the Spot Rate Works

The way it works is simple because the spot rate is the price you pay for something at a
specific point in time.

A commodity, security, or currency has a specific price that you pay to immediately settle a
trade. Its price can change daily depending on what you buy or sell.The spot price is usually
influenced by the number of people buying and selling the asset in question.

For bonds, the spot rate is the rate you would pay if you bought the bond at a particular point
in time.

Types of Spot Rates

Spot rates are displayed for a variety of assets and interest rates, including commodities, bond
rates, exchange rates, and securities.
The spot rate is the price of an asset that can be exchanged immediately. However, the futures
rate is the agreed price at which the asset will be exchanged at a later date. Forward rates are
a function of forward contracts and are set by parties.

All details of the forward contract including price, settlement date and amount of assets to be
exchanged are determined when the contract is created. However, no exchange of money or
assets will take place until the specified settlement date has arrived. Standardized forward
contracts traded on exchanges are called futures.

3.4 Summary
⮚ The forex market is the over-the-counter (OTC) market that determines the exchange
rates of world currencies.
⮚ It is by far the world's largest financial market and comprises a global network of
financial centers that trade 24 hours a day and are closed only on weekends.
⮚ Currencies always trade in pairs, so the "value" of one currency in that pair is relative
to the value of the others.
⮚ An indirect quote in the foreign exchange market represents the amount of foreign
currency required to buy or sell one unit of the domestic currency.
⮚ Indirect quotes are also called "quantity quotes" because they represent the quantity of
foreign currency required to purchase a unit of the domestic currency.
⮚ The opposite of an indirect quote is a direct quote that represents the price of one unit
of a foreign currency with a variable number of units of the local currency.
⮚ A forward rate is the expected interest rate or yield on future investments in bonds or
currencies, as well as future loans/liabilities. In addition to interest rate, maturity is
another factor in that calculation.
⮚ Investors can choose from multiple investment options, such as US Treasury bills (T-
bills), using spot rates and yield curves.
⮚ It is frequently used for hedging and is considered an economic indicator that helps
investors reduce risk in currency markets.
⮚ The difference between forward yield and spot rate is that the latter represents the
current interest rate or the yield of a bond and must be settled and delivered on the
same day.
⮚ The spot rate is the price of a physical or financial asset in instant settlement
transactions.
 ⮚ Construct an interest rate term structure using spot rates for zero-coupon bonds of
various maturities.
⮚ Unlike the spot rate, the forward rate is the agreed price for an asset that will be
exchanged at some point in the future.

3.5 References

1. Foreign Exchange Management and International Finance, 2/e- Vivek Viswan V. &
M. M. Sulphey
2. Foreign Exchange Management- Esha Sharma