Fundamentals in Exchange Rate

Fundamentals in Exchange Rate

Typically, rupee (INR) a legal lender in India as exporter needs Indian rupees for payments for procuring various things for production like land, labour, raw material and capital goods. But the foreign importer can pay in his home currency like, an importer in New York, would pay in US dollars (USD). Thus it becomes necessary to convert one currency into another currency and the rate at which this conversation is done, is called ‘Exchange Rate’.

            Exchange rate is a rate at which one currency can be exchange in to another currency, say USD 1 = Rs. 42. This is the rate of conversion of US dollar in to Indian rupee and vice versa.

METHODS OF QUOTING EXCHANGE RATES

There are two methods of quoting exchange rates.

• Direct method:

            For change in exchange rate, if foreign currency is kept constant and home currency is kept variable, then the rates are stated be expressed in ‘Direct Method’ E.g. US $1 = Rs. 49.3400.

• Indirect method:

            For change in exchange rate, if home currency is kept constant and foreign currency is kept variable, then the rates are stated be expressed in ‘Indirect Method’.  E.g. Rs. 100 = US $ 2.0268

          

In India, with the effect from August 2, 1993, all the exchange rates are quoted in direct method, i.e.

US $1 = Rs. 49.3400         GBP1 = Rs. 69.8700

• Method of Quotation

            It is customary in foreign exchange market to always quote tow rates means one rate for buying and another for selling. This helps in eliminating the risk of being given bad rates i.e. if a party comes to know what the other party intends to do i.e., buy or sell, the former can take the latter for a ride.

            There are two parties in an exchange deal of currencies. To initiate the deal one party asks for quote from another party and the other party quotes a rate. The party asking for a quote is known as ‘Asking party’ and the party giving quote is known as ‘Quoting party’

THE ADVANTAGE OF TWO-WAY QUOTE IS AS UNDER:

1.      The market continuously makes available price for buyers and sellers.

2.      Two-way price limits the profit margin of the quoting bank and comparison of one quote with another quote can be done instantaneously.

3.      As it is not necessary any player in the market to indicate whether he intends to buy of sell foreign currency, this ensures that the quoting bank cannot take advantage by manipulating the prices.

4.      It automatically ensures alignment of rates with market rates.

5.      Two-way quotes lend depth and liquidity to the market, which is so very essential for efficient.

            In two-way quotes the first rate is the rate for buying and another rate is for selling. We should understand here that, in India, the banks, which are authorized dealers, always quote rates. So the rates quote – buying and selling is for banks will buy the dollars from him so while calculation the first rate will be used which is a buying rate, as the bank is buying the dollars from the exporter. The same case will happen inversely with the importer, as he will buy the dollars form the banks and bank will sell dollars to importer.

BASE CURRENCY

            Although a foreign currency can be bought and sold in the same way as a commodity, but they’re us a slight difference in buying/selling of currency aid commodities. Unlike in case of commodities, in case of foreign currencies two currencies are involved. Therefore, it is necessary to know which the currency to be bought and sold is and the same is known as ‘Base Currency’.

BID &OFFER RATES

            The buying and selling rates are also referred to as the bid and offered rates. In the dollar exchange rates referred to above, namely, $ 1.6290/98, the quoting bank is offering (selling) dollars at $ 1.6290 per pound while bidding for them (buying) at $ 1.6298. In this quotation, therefore, the bid rate for dollars is $ 1.6298 while the offered rate is $ 1.6290. The bid rate for one currency is automatically the offered rate for the other. In the above example, the bid rate for dollars, namely $ 1.6298, is also the offered rate of pounds.

4.3.5 CROSS RATE CALCULATION

            Most trading in the world forex markets is in the terms of the US dollar – in other words, one leg of most exchange trades is the US currency. Therefore, margins between bid and offered rates are lowest quotations if the US dollar. The margins tend to widen for cross rates, as the following calculation would show.

Consider the following structure:

GBP 1.00 = USD 1.6290/98                               

EUR 1.00 = USD 1.1276/80

           

In this rate structure, we have to calculate the bid and offered rates for the euro in terms of pounds. Let us see how the offered (selling) rate for euro can be calculated. Starting with the pound, you will have to buy US dollars at the offered rate of USD 1.6290 and buy euros against the dollar at the offered rate for euro at USD 1.1280. The offered rate for the euro in terms of GBP, therefore, becomes EUR (1.6290*1.1280), i.e. EUR 1.4441 per GBP, or more conventionally, GBP 0.6925 per euro. Similarly, the bid rate the euro can be seen to be EUR 1.4454 per GBP (or GBP 0.6918 per euro). Thus, the quotation becomes GBP 1.00 = EUR 1.4441/54. It will be readily noticed that, in percentage terms, the difference between the bid and offered rate is higher for the EUR: pound rate as compared to dollar: EUR or pound: dollar rates.