Foreign Exchange Rates Calculations

Foreign Exchange Rates & Quotations:

Foreign Exchange market

American term-

European Term

0.4575 per CHF

EUR 1.0275 per USD

USD 1.3542 per GBP CHF 1.4500 per USD INR 46.75 per USD

American Terms: It is quoted as a number of US$ per unit of local currency. $/Rs is an American Quote.

European Terms: It is quoted as a number of units of local currency per US$ dollar. Rs/$ is a European quote.

Direct Quote

Indirect quote (Reciprocal/Inverse quote)

INR 46.00 per USD in US

USD 2.2560 per INR 100 in India Stated as the no of units of a foreign Currency per unit of home currency.

Direct Quote: In India Rs/$ is a direct quote. In France FF/$ or FF/t is a direct quote. Direct quotes are those that give units of the local currency per unit of a foreign currency. Indirect Quote: Indirect quote is stated as number of units of foreign currency per unit of the home currency. In India $/Rs, In London $/t, in Germany DM/t is an indirect quote. It is also called Inverse quote or reciprocal quote.

“Bid” and “Ask” will always be from the bank’s point of view. The bid rate will always be lower than the ask rate.

Mechanics of Currency trading: Inter bank market deals are done on the telephone. When asked to quote a price between Rupees and dollar, a banker gives a ‘two-way quote’, he quotes his two prices.

Rs/$: 45.35 /45.60 In the above example: 45.35 is the “bid” rate and 45.60 is the “ask/offer” rate or

BID RATE: A price at which one will buy a currency in exchange for another currency. Rs 45.35/ $ is the price at which the other banker is willing to buy a Dollar from the customer and exchange (pay to the customer) Rs.45.35. This is called Bid rate. Here it is the rate of Indian rupee he is willing to pay to buy one USD.

Bid Rate: It is the price at which one is willing to buy a dollar in exchange for Indian rupees. Bid – the price at which the dealer giving quote is prepared to buy- “bidding for”

ASK/OFFER RATE: Rs.45.60 is the price at which the other banker is willing to sell a Dollar to the customer and take Rs.45.60 and give one Dollar. This is called Ask or offer rate. Ask/offer price – the price at which the dealer is willing to sell is “offering” one unit of base currency. It is the amount of quoted currency the dealer will want to be paid in return for one unit of the base currency.

USD/ CHF -

US Dollar – Swiss franc

Base currency

quoted currency

Bid – offer spread: Difference between the ask rate and bid rate is called Bid- ask spread. This margin is the market makers compensation for the costs incurred and normal profit on capital invested in the dealing.

Forward Quotations: Forward quotations are rates quotes for a currency against a particular currency. It specifies the rate at which one is willing to buy or sell (bid/ask) after a particular month /year. Forward contracts: They are agreements between two parties. It is a simple contract to take delivery at an agreed price, quantity & time in the future.

Short position: If a dealer dealing in foreign exchange has sold more dollars / currencies than he has bought then he is said to take a net short position.

Long position: If a dealer dealing in dollars/ other currencies has purchased more dollar / other currencies than he has sold, then he is said to take a long position.

Due to the high volatility of exchange rates, maintaining a short or long position for too long can be a risky proposition. Building and carrying a net position for a long duration would be equivalent to speculation and banks exercise tight control over their traders to prevent such activity.

Zero sum game: Most of the trading takes place between market making banks, gains made by one banker is reflected in losses made by another.

Vehicle currency: A common currency is generally used for quoting various currencies in trading in order to economize the number of quotations. In general US$ is used as vehicle currency as bulk of the trading of convertible currencies takes place against US$. In ordinary foreign exchange transaction, no fees are charged, as ‘bid- ask’ spread itself is the transaction cost. Unlike the money or capital markets, where different rates of interest are charged to different borrowers depending on their credit worthiness, in the foreign exchange market no such distinction is made.

Default risk: In order to reduce the risk wherein a counter party in a transaction may not deliver on its side of the deal, limits are prescribed on the size of positions a trader can take…

SWIFT: All transactions in the over- the counter is generally done through the communications network established by this non- profit Belgian co-operative called SWIFT- Society for World Wide Financial Telecommunication. It has a main and regional center, which is connected by telecommunication lines.

Settlement date or value date: the days on which settlements are effected are called settlement date or value date.

Dealing locations: The location of the two banks involved in the trade is dealing location. The location at which dealings done are called dealing locations. In case State Bank Of India, Bombay enters into a deal with Citibank, New York, Bombay and New York are called dealing locations.

Settlement location: places which banks location are credited and debited are called settlement location. Ex: In case a deal is made between SBI, Bombay and Citibank, New York and SBI, Bombay request the Citibank to transfer the proceeds to SBI, Calcutta and Citibank transfer the dollar from Citibank, San Francisco, the settlement locations in this case is Calcutta & San Francisco. Similarly, a London bank can sell Swiss francs against USD to a Paris bank. The settlement can be between the London bank’s branch at New York and Paris bank’s branch at Geneva. These NY and Geneva branches are called settlement location (on the day of settlement, banks in New York and Geneva should be opened).

How settlements are made:

Spot transaction: The settlement date or value date- 2 working days is given for settlement. I.e, two working days from the date of spot transaction should be the settlement date.

In case of forward transaction- find the value date for spot transaction between the two countries and add one calendar month to arrive at the value date.

Rolling forward: For rolling forward settlement of 3 months, find the spot date and add 3 months to the spot date. If the rolling date is ineligible you can shift forward to the next day and if it happens to be another month, it must be shifted backwards. Ex: If Nov 26 is the date deal was made, spot will be Nov 28th plus 3 months i.e 28 the Feb & if it is holiday, it cannot be moved to March 1st as this goes to the next month and hence it must be settled on 27th of Feb.

Broken date or Odd date: Banks offer forward contract for maturity that are not whole month (say 73 days) such contracts are called “broken date” or “odd date”

Expressing Forward Quotations on a point Basis: When quotations are given as USD/INR: 45.4250/ 45.4290, the last two digits 50 in bid and 90 in quote are called “points” or “pips”. The difference between the offer rate and bid rate is 40 points or 40 pips. If the USD/INR: 45.4255 / 45.4295, it is said that the USD has moved up 5 pips. When two dealers converse with each other, this is normally shortened as 50/90 which means that the first four digits 45.42 known as the “big figure” and the professional dealers are suppose to know what the big figure is.

Note: It must be remembered that the offer rate must always be greater than the bid rate. The convention of representing A/B where the rate being given as number of units of B per unit of A will be little confusing as in mathematical fraction A/B means A is divided by B, that is number of units of A per unit of B.

Mechanics of Inter- bank (Primary market makers) trading: Primary market makers trade on their own and make a two way bid – offer market.

Inter- bank dealing:

A typical spot transaction between two dealers as follows:

Date: Sep 21. Bank A: ‘Bank A calling. DLR-CHF 25 please. (Bank A is asking for a Swiss franc versus USD quote for a size of 25 Million Dollars which is more than the “market lot” of 10 million. Bank B: “fifty- fifty two. (Means Bank B will buy a USD against Swiss francs at ’50 and sell a US dollar @ 52. Here both know the big figure of 1.45 and the last two decimals are only quoted.) 40 and 52 are pips in the forex jargons. Bank A: “Mine” (Means A is willing to buy 25Millions of USD against Swiss francs from B who has offered to sell at 52 i.e 1.4552. If she wishes to sell, she might have said yours.)

Bank B: OK. I’ll sell USD 25 Million against CHF @1.4552 value 23, Sept.UBS, Geneva for CHF. (Bank B confirms the quantity, price and settlement date. Also specifies where it would like its CHF to be transferred)

When a dealer A calls another dealer B and asks for a quote between a pair of currencies, dealer B may or may not wish to take on the resulting position on his own books. If he does, he will quote a price based on his information about the current market and the anticipated trends and take the deal on his own books. This is known as ‘warehousing the deal”. If he does not wish to warehouse the deal, he will immediately call a dealer C, get his quote and show that quote to A. If A does a deal, B will immediately offset it with C. This is known as “back to back “dealing. Normally back- to- back deals are done when the client asks for a quote on a currency, which the dealer does not actively trade in.

Arbitrage: Arbitrage in finance refers to a set of transactions, selling and buying or lending and borrowing, the same assets or equivalent (having identical cash flows and risk characteristics) group of assets, to profits from price discrepancies within a market or cross-markets. No risk or capital is involved. In foreign exchange market, it is not possible for all banks in different parts of the world to give identical quotes for a given pair of currencies at a given point of time. Buying a currency where it is cheaper and selling it in a market where it is costlier, you make a profit without any involvement of capital or risk is called arbitrage.

Suppose two banks A and B in two different countries quote the following rates:

A : Rs/$: 45.6115/ 45.6170

B: Rs/$: 45.6085/45.6095 US$ can be bought from Bank B @45.6095 and can be sold at 45.6115 for a net profit of 45.6115 – 45.6095 = 0.0020 per dollar without any risk or commitment of capital.

Problem: On a particular day, the following quote is available from a bank. DM/$: 1.6225/35. Explain the quotation. Explain the implied inverse quote $/DM. Another bank quotes $/DM: 0.6154/59. Is there an arbitrage opportunity? If so, how would it work? Solution: DM/$:1.6225/35 DM/$:1.6225/1.6235 This means that the bank is willing to buy a Dollar @1.6225DM and willing to sell a $ for Rs.1.6235.1.62 is the big figure and 25/35 is called points or pips.

DM/$: 1.6225/1.6235 $/DM : 1/1.6235 / 1/1.6225 : 0.6159/ 0.6163 B: $/DM:= 0.6154/0.6159 Arbitrage is not possible as the price at which you can buy from B & the price at which A is willing to purchase are same. There is no arbitrage.

Problem: The following quotes are available from two banks: A: FF/$ spot: 4.9570/80

B: FF/$ spot: 4.9578/90 Is there any arbitrage opportunity? What kind of market will result? What might be the reason for this?

Solution: A: FF/$: 4.9570/ 4.9580 B: FF/$: 4.9578/44.9590 The selling price of A is 4.9580 and the buying price of B is 4.9578. Hence there is no arbitrage. The selling price of B is 4.9590 & the buying price of A is 4.9570. Hence there is no arbitrage. B will find that it is hit on its bid side.

Problem: The buying rate of SFr in New York is $0.5910. A corporate treasurer is going to buy SFr in Zurich at SFr/$ 1.6650 and sell them in New York. Will he make a profit? If yes, then how much? Solution: Buying Rate of SFr/$ in Zurich spot = 1.6650 $/SFr= 1/1.6650 = 0.60060 Price of SFr in Zurich = 0.60060$. Price of SFr in N.York= 0.5910$ He is going to incur a loss of 0.0090$ in New York.

Problem: Stated below is a table of cross rate: Analyze the various arbitrage possibilities:

Center

DM

Frankfurt

-

New York

0.4421

$

FF

‘t’

2.2812

0.4712

4.0218

-

0.2110

1.8006

Paris

2.0949

London

4.0207

4.7393

1.7775

-

8.4232

8.4301

-

(Indirect quote)

Solution: $: 1.DM/ $ in Frankfurt is 2.2812 & in New York is 2.2619(1/0.4421= 2.2619) Hence buy in New York and sell in Frankfurt.

2. FF/FF in Paris is 4.7393 and in New York it is 4.7393(1/0.2110 = 4.7393) Hence there is no arbitrage.

3. t/$ in London is 0.5625 & in New York it is 0.5553 (1/1.7775= 0.5553) Buy $ in New York and sell in London.

FFr: 1. DM/ FFr in Frankfurt is 0.4712 & in Paris is 0.4773. Buy FFr in Frankfurt & sell in Paris.

2. $/FFr in New York is 0.2110 & in Paris is 0.2110(1/4.7393 = 0.2110). Hence there is no arbitrage.

3. t/FFr in London is 0.1187 & in Paris is 0.1186(1/8.4301)

DM: 1. $/DM in Frankfurt is 0.4383(1/2.2812= 0.4383) & in New York it is 0.4421. Hence buy in Frankfurt and sell in New York.

2. FFr/DM in Paris is 2.0949 and in Frankfurt it is 2.1222(1/0.4712= 2.1222). Hence buy in Paris and sell in Frankfurt.

3. T/DM in London is 0.2487(1/4.0207= 0.2487) & in Frankfurt is 0.2486(1/4.0218 = 0.2486). Hence buy ib Frankfurt and sell in London.

‘t’: 1. DM/t in London is 4.0207 & in Frankfurt it is 4.0218. Hence buy in London and sell in Frankfurt.

2. $/t in New York is1.8006 & in London it is 1.7775. Hence buy in London and sell in New York.

3. Ffr/t in Paris is 8.4301 and in London it is 8.4232. Hence buy in London and sell in Paris.

Problem: In London a dealer quotes: DM/t spot: 3.5250/55. Y/t spot: 180.80/181.30. What do you expect the Y/DM rate to be in Frankfurt? Suppose that in Frankfurt you get a quote Y/DM spot 51.1530/51.2550, is there any arbitrage possibility?

Solution: DM/t spot: 3.5250/3.5255, Y/t spot : 180.80/181.30

Y/DM = Y/t x t/DM

= 180.80 x 1/3.5255 181.30 x 1/1/3.5250

= 51.2821

51.4311

= 51.2821/ 51.4311

In Frankfurt if the rate of Y/Dm is 51.1530/ 51.2550 and in London it is 51.2821/51.4311. Buy in Frankfurt and sell in London.

Problem: The following quotes are obtained in New York: $/t: 1.5275/1.5285

SFr/$: 1.5530/1.5535

What rate do you expect for SFr/t spot in London? If a London bank quotes 2.3730/2.3740, can you make arbitrage profit? If so then how? Solution:$/t = 1.5275/1.5285 SFr/$= 1.5530/1.5535 SFr/t = SFr/$x $/t = 1.5530x 1.5275 = 2.3722 1.5535

1.5285

2.3745

SFr/t = 2.3722/2.3745

If London quote is 2.3730/ 2.3740 No arbitrage is possible.

Problem: An importer purchased materials from Swiss worth FFr 85,000. There is no quote available for Rs against SFr. However the following quotes are available. Rs/$: 45.0170/ 45.0190 & SFr/ $ = 1.6650/ 1.6675. What will be the value of Indian Rupees the bank will ask the customer. Solution: Rs/SFr = Rs/ $ x $ / SFr

= 45.0170 x 1/1.6675 45.190

1/1.6650

= 45.0170 x 0.5997 = 26.9967 45.0190 0.6006

27.0384

= 26.9967/27.0384

The bank will charge Rs.27.0384 for SFr. For 85,000 SFr it will charge 85,000 x 27.0384 = Rs.22,98, 264.

Problem: An importer has purchased goods from Germany worth DM60,000. A direct quote was not available. However the following quotes were available. Rs/FF: 6.8558/ 6.8609 T/FF: 0.1187/0.1195 T/DM: 0.2487/0.2502 What will be the value of money bank will ask from the customer. Solution: Rs/DM: Rs/FF x FF/t x t/DM

= 6.8558 x 1/0.1195 x 0.2487 6.8609

1/0.1187

0.2502

= 6.8558 x 8.3682 x 0.2487 6.8609

8.4246

0.2502

= 14.2681/ 14.4616 Bank will charge Rs.14.4616 per DM. The customer will have to pay 60,000 x Rs.14.4616 = Rs.8,67,696.

Problem: On Feb 24,2004, a customer requested a bank to remit DeutchGuilder 2,50,000 to Holland for payment of import of Diamonds under IR L/C. However due to strike the bank could payment on March 1,2004, the inter bank rates were as follows: Center

Feb 24,2004

March1, 2004

$/Rs(100)

$/Rs(100)

1. Mumbai-N.Y.

3.10/3.15

3.07/ 3.12

2.NewYork-London

$/t 1.7250/1.7260

$/t 1.7175/1.7185

3.Amsterdam- London

DG/t 3.9575/3.9590

DG/t 3.9380/ 3.9390

Bank wants to charge a commission of 0.125%. How much the customer stands to gain/loss due to delay. Solution: If the payment had been effected on Feb 24th 2004. Rs/DG= Rs/$ x $/t x t/DG = 31.7460 x 1.7250 x 0.2526 32.5733

1.7185 0.2539

= 13.8328 14.0696 DG 2,50,000 x 14.0696 x 1.125 = Rs.39,57,075 =00 Payment made on March 1, 2004. RS/DG = Rs/$ x $/t x t/DG = 32.0513 x 1.7175 x 0.2539 32.5733

1.7185 0.2539

= 13.9767 14.2126

DG 2,50,000 x 14.2126 x 1.125 = Rs.39,97,293 = 70 The loss was Rs. 39,97,293=70 – Rs.39,57,075 = 00

= Rs.40,218 = 70