Foreign exchange arithmetic

1
FOREIGN EXCHANGE
ARITHMETIC
Rajat Prasad
Certified Treasury Professional
rajatprasad@gmail.com

2
Session Objectives
In this session, you will be able to:
▪ Demonstrate how the actual calculations are made while
applying the different types of rates to the different types of
transactions.
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3
Foreign Exchange Arithmetic
• To understand the concepts which we have seen so far, it is
necessary to work out some arithmetical examples – to see how
the banks actually deal with the customers.
Example 1:
Market rate 1 US$ = Rs. 64.91/92.
Forward margins (in paise): 1 month: 28/29, 2 months: 53/55, 3
months: 75/77, 6 months:137/140.
Whether the forward $ is in premium or discount?
Find the outright forward quotes for all the four periods.
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Currency Bid Ask
USD/INR 64.91 64.92
EUR/USD 1.2308 1.2310
USD/JPY 105.95 105.97
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Example 2:
• In the same example above, find the rates for merchants (customers)
by loading exchange margin of 0.08% for buying rates and 0.15% for
sale rates.
Assuming a service charge of Rs. 200/- for issue of DD,
• How much amount the customer would be paying to the bank for a
DD of US$ 10000/- on New York?
Solution:
• Load the exchange margins on the respective inter bank rates (deduct
for buying rates and add for selling rates) and
• Then round off to the lower .0025 for buying rates and
• To the higher .0025 paise for selling rates while quoting to customers.
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• Solution:
• Since the forwards are in the ascending order, the Forwards are
premia.
• So by adding the forwards to the spot rates,
• we get the outright forward rates for 1m, 2m, 3m and 6m
respectively as:
• 1m: 65.19/21,
• 2m: 65.44/47,
• 3m: 65.66/69 and
• 6m: 66.28/32
• These are inter-bank forward rates.
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The merchant rates(rates to the customers) are:
• Spot: 64.8575/65.0175
• 1m: 65.1375/65.31
• 2m: 65.3875/65.57
• 3m: 65.6075/65.79
• 6m: 66.2250/42
• The Draft for $10,000 will be issued at the spot rate of 65.0175.
• Therefore the amount to be recovered from the customer is
Rs.6,50,175 + Rs. 200 i.e. Rs.6,50,375
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Let us now calculate spot rate of Euro/INR
Selling Rate :
1 Eur = 1.2308 (USD)
1 USD = 64.91 (INR)
So 1 Euro = 1.2308 X 64.91 = 79.8912 INR
Buying Rate
1 Eur = 1.2310 (USD)
1 USD = 64.92 (INR)
So 1 euro = 1.2310 X 64.92 = 79.9165 INR
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9
Let us now calculate spot rate of JPY/INR
Selling Rate :
1 USD = 105.97 (JPY) ……………(Why) so 1 JPY = 1/105.97 $
1 USD = 64.91 (INR)
So 1 JPY = 64.91 / 105.97 = 0.6125 INR
Buying Rate
1 USD = 105.95 (USD) so 1 JPY = 1/105.95 $
1 USD = 64.92 (INR)
So 1 JPY = 64.92 / 105.95 = 0.6127 INR
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Transaction Cancellation
Principles to be applied for cancelling the purchase and sales
transactions of customers:
If a purchase transaction is to be cancelled,
• it is to be done at the appropriate market sale rate (plus margin:
0.15%)
If a sale rate is to be cancelled,
• then it should be done at the appropriate market buying rate
(minus margin: 0.08%)
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Example 3:
• The customer who purchased a DD in the example 2 has now come
to the bank for cancellation of the same.
• Now the market rates are 65.1525/1625.
• A service charge of Rs. 200/- is applicable for the cancellation.
• Find the actual profit or loss of the customer in the transaction
Solution:
• DD was sold.
• So cancellation is at the TT Buying rate, which is Rs.
65.1525*0.9992= Rs. 65.10 on rounding off.
• So the amount payable to the purchaser of the DD is Rs.6,51,000-
200=Rs.6,50,800/-.
• Profit for the customer: Rs. (now to be received by him ) 6,50,800 -
(Originally paid by the customer) 6,50,375- =Rs.425
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• While cancelling, the amount of shortfall or surplus if any
(differences between the original amount and the cancellation
amount) have to be recovered or given to the customer as the case
may be.
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Some more principles:
• When the foreign currency is in premium, the currency accrual
date (if in incomplete periods) is rounded off to the previous
complete period while quoting buying rates,
• Currency delivery period (if in incomplete periods) is rounded
off to the next complete period while quoting the sale rate.
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• Conversely, when the currency is in discount, the currency accrual
period is rounded off to the next complete period while quoting
the buying rate.
• Currency delivery period is rounded off to the previous complete
period while quoting sale rate.
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15
Example 4:
A customer of a bank presents export documents for US$ 1 mn. on
‘sight’ basis, drawn on a customer in London.
The market rates at the time are:
• 1 £ = 96.1316/1410
• 1 US$ = Rs. 66.0510/90
• Forward margins for £ are (paise): 1month: 46/47, 2months:
92/94, and 3months: 140/145;
• Forward margins for $ are (paise): 1 month: 35/36, 2 months:
77/79, 3 months: 115/118 and six months: 175/179.
• Assuming that the ‘Normal Transit Period’ (NTP) for $
documents in UK/Europe is 25 days, exchange margin is 0.15%,
and the bank deducts interest for the NTP in advance @9.50%
p.a.
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Hint:
• Find the rupee equivalent that the customer will get from the bank.
(Hint: NTP is the time taken for the bill to reach the foreign bank,
presented to the importer customer, paid by him and proceeds
credited to the ‘nostro’ account of the bank and so currency will
accrue to the bank only after this period)
Solution:
• Since the bill is in US$ for which the rate is readily available, the
data about £ is irrelevant.
• While fixing the rates, the bank has to see the date of currency
accrual to the bank in the nostro account in the purchase
transactions.
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• The date of debit to the nostro account in the sale transactions,
then load the appropriate forward margins, then load the profit
margins, and then round off and quote the rates.
• US$ will accrue in the nostro account in 25 days. So the bank
has to look to the forward rate for 25 days which is either 3
weeks or 1 month in practice. But since the currency is in
premium, the bank will not give the advantage of the premium to
the customer and so will round off the 1 month to the spot.
• So the market rate to be considered is the spot buying rate which
is Rs. 66.0510.
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• After loading the margin of 0.15% and rounding off,
the rate comes to Rs. 65.9519
• The amount of the $ 1 mn. Documents is
= Rs. 6,59,51,900. Int. @9.5% for 25 days
= Rs. 6,59,51,900*9.50/100*25/365= Rs 4,29,139
• So, the net credit to the account of the customer
= 6,59,51,900 - 4,29,139
= Rs. 6,55,22,761
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Example No. 5.
• If in the above example, if the customer had given a 2 months’
‘usance’ bill for the same amount, instead of a ‘sight’ bill, what
would be the net amount the customer get from the bank.
Hint:
• When the bill is presented to the importer customer, he is entitled
to 2 months credit period to pay the bill amount and hence the
nostro account of the bank is likely to be credited with the bill
proceeds at the expiry of the usance period plus NTP of 25 days
i.e. 85 days)
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Solution:
• Since the currency is in premium and the currency will accrue in
the nostro account of the bank at the end of 2 months + 25 days,
the bank will round off the premium to 2 months and
• Hence the market rate to be considered is: 66.0510+0.77 =
66.8210.
• After loading the margin of 0.15% and rounding off, the rate to the
customer will be: Rs. 66.7200 and the amount of the bill comes to
Rs. 6,67,20,000
• Interest on this amount for 85 days @ 9.50% comes to
Rs.14,76,066.
• So the net credit to the customer’s account will be Rs.
6,67,20,000-Rs. 14,76,066=Rs.6,52,43,934
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Swaps:
• Swap is a single transaction in which the same amount of a currency
is simultaneously bought and sold (or sold and bought) for different
maturities.
Examples:
• Cash purchase against tom sale,
• Cash against spot,
• Tom against spot,
• Spot against 1 month forward ,
• Spot against 2 months forward ,
• 1 month forward against 3 months forward etc.
• These transactions are done so as to eliminate the ‘gap’ arising in the
maturity of the purchase and sale transactions that go on occurring
while dealing with customers and other banks and over which banks
have no control.
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Example:
• A bank purchases in spot an export bill at sight for say US$ 1
lakh, and also sells ‘cash’ US$ 1 lakh to an importer.
• Here the currency ‘position’ is neither ‘over bought’ nor ‘over
sold’ but ‘square’.
• So the bank has no exchange rate risk. (The exchange risk that
arises from one transaction is cancelled by the other opposite
transaction)
• However, the bank has a maturity ‘gap’ in the transactions of 20
days since, the export bill proceeds would be credited to the
nostro account after 20 days (NTP), whereas the debit in the
nostro account would appear on the same business day as the sale
transaction, thus resulting in overdrawal in the account.
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• So, to avoid the overdrawal, the bank will buy US$ 1 lakh from
the market in ‘cash’.
But now the bank is ‘overbought’, even though the gap is
eliminated.
• So the bank has to sell US $1 lakh 20 days forward by which
time, the credit in respect of the export proceeds would have also
appeared.
• This action will eliminate the overbought position and will also
eliminate the gap.
• Instead of doing 2 different transactions-one purchase and one
sale- to correct the gap, the bank will do a single ‘swap’
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• The banks will be doing purchases and sales (in many currencies)
for different maturities for differing amounts from customers
resulting in overbought or oversold positions and gaps of differing
periods.
• So the banks also have to do swap transactions for differing ‘legs’
(two sides of the transaction) to correct the mismatches in
maturities of purchases and sales.
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• When forward contracts are booked by customers, on many
occasions, the customers are forced to either advance or postpone
the period of delivery, depending upon their customers’ (i.e.
trade counterparties) convenience and need.
• Then they approach the banks for alterations of delivery periods
in their forward contracts.
• The merchants can go in for any of the two types of forward
contracts:
• ‘Fixed date forward contract’ in which the date of delivery is
fixed.
• The other one ‘Option Forward contract’ in which he exercises
his option to complete the contract within an ‘option’ period of
one month.
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• The time interval between the beginning and ending dates of the
option period cannot exceed one month- but the beginning date of
the option forward contract may fall even after 1year.
• An example of a fixed date forward contract is a one with
delivery date on October 27 and of an option forward contract is a
one with option delivery period from December 1 to December 31.
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• Initially, as soon as the forward contracts are booked for the
customers, the banks ‘cover’ themselves in the markets by doing
the opposite transactions, so as to avoid exchange risk.
• (Forward Purchase contracts with customers are covered by
Forward Sale contracts with other market participants and vice
versa)
• So, to accommodate the customers’ requests for alterations, the
banks have to do swaps in the market.
• The losses or profits in these swaps are passed on to the
customers’ accounts while altering the original forward contracts
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• In the case of extension of forward contracts by the customers, the
bank may have to reassess the risk with reference to the
fluctuations in the value of the currency, the financial position of
the merchant etc. before extending the commitment.
• The bank will first cancel the existing contract and rebook it for
the new extended period.
• Further if there is some outlay of funds of the bank from the
period of original maturity to the extended maturity, the bank will
also charge interest on the additional outlay amount.
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Exercise
A customer wants to remit a sum of US$ 50,000 to his son studying
in the USA. When he approaches the bank for the remittance, the
bank observes the market rates as follows:
• Spot: 66.17/18; forward margins (in paise):1 month: 16/17; 2
months: 31/33; 3 months: 46/48.
• Bank loads exchange profit of 0.15% on the market rate for this
transaction. A flat charge of Rs.300 is also applicable.
• Find the amount of debit to the customer’s account in this
transaction .
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COMPUTERISED TRADING
SYSTEMS,
DEALER’S PSYCHOLOGY
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Computerised Trading Systems, Dealer’s Psychology
• There are so many sophisticated trading systems available in the
market.
• They are capable of producing a variety of MIS in a fraction of a
second to reduce the burden of the dealers in taking decisions.
• A cool, disciplined dealer will take an average system and make
money with it. A nervous dealer will take a brilliant system and
wreck it.
• (The words dealer / trader and deal / trade are used
interchangeably and mean the same thing in the context of forex
dealings)
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• A dealer has to write down his plan for each trading day, before
trading starts.
• His trading plan has to cover every eventuality and he should
know what to look for in the market, when to get into trade and
when to get out.
• The higher the amount of the deal, the more emotional the dealer
is likely to become.
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• A dealer should never get emotional about trading. The current
trade is only one of a long series of trades.
• The dealer should watch the screen how the rates move and do
some trades in the mind – not actually - and see what happens.
• In doing these mental trades, the dealer cannot become emotional.
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• He may make profits or losses but after some practice, he will
make overall profits.
• A dealer should practice this strategy if he has to be successful in
the long term.
• For a dealer a ‘winning day’ or a ‘losing day’ is not important but
his long term overall performance is.
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• There are times when any dealer makes mistakes under pressure,
but he should never crack under pressure. i.e. the dealer should
never panic.
• A dealer should never trade and do something else also at the
same time.
• He should learn to make trades in a relaxed, but focused way.
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• Less is more – how?
• It has been proved that less number of well-done deals rakes in
more profits rather than more deals done in a hurry.
• The dealer can write his daily diary to record his trades when he
makes profits and losses.
• A week end review will add a lot of experience and expertise than
a good trading system.
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• The most obvious way to relieve pressure is to think in terms of
probabilities and carefully manage risk.
• It's useful to remember that the dealer may not win on any single
trade; but after a series of trades, he will have enough winners to
make a profit in the long run. It's also important to manage risk.
• He has to determine his risk up-front and risk only a small amount
of trading capital on a single trade.
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• Doing so will ease a lot of the pressure, allowing him to be more
open to see the opportunities that the market offers.
• He should never crack under the pressure of a potentially mortal
financial defeat.
• He should consider the possibility, and be ready to recover from it.
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Information analysis for trading
• For conducting successful trading, the trader has to analyse different
types of information that are coming in steadily at various intervals
and each one of them has some implications for the exchange rate
movements.
• Most of the software providers themselves provide these information
also.
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They come in the form of currency message boards, and provide:
• Trading recommendations,
• Live charts of currency movements,
• Live currency pair quotes,
• Statistics on daily volume of trading in various currency pairs,
• Currency movement forecasts etc.
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• Economic Indicators
• Economic indicators can be anything, from seemingly insignificant
pieces of financial and economic news, to the data published by
different agencies on the statistics of government or private sector
• The major economic indicators are :
▪ Industrial production,
▪ Producer Price Index,
▪ Retail Sales,
▪ GDP,
▪ New housing demand etc.
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• Such data helps in keeping track of the latest developments in the
nation’s financial sector.
• Market observers are constantly keeping an eye on the overall
economy and its effect on the market.
• Such indicators are consistently tracked by nearly everyone related
to the financial markets in some way or another.
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• Thus the economic indicators contain great potential for creating
levels and moving currency prices along with the whole markets,
as so many people respond to the same data together.
• To make full use of these economic indicators in the Forex market
and trading world, the dealer should always be aware as to when
each economic indicator is due to be out in the markets.
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• Just because the forex market is open 24 hours it does not mean
that all those 24 hours, it is moving in the dealer’s favour.
• There will be some hours or minutes or even moments when the
market can move against.
• Trading during those circumstances is never advisable. Trade
should only be done when the dealer is sure that the market is
most expected to go with him.
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• For example, the markets are known to go in slumber during the
days when London and New York are closed.
• This is exactly where technical indicators are useful.
• But, for checking the authenticity of these technical indicators, the
best way is the trading volume.
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• It is believed that these indicators turn out to be more accurate
when the trading volume is high.
• But since there are no trading volume records obtainable in the
Forex markets, it is advisable to make use of trading ranges, which
is the next good option.
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• Trading range can be defined as the difference established
between the high and low price limit for a specific currency pair
over a specified time period like one trading day.
• With this approximate data in hand, a dealer can now more
precisely and cautiously calculate when is the right time for him to
trade.
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• Technical indicators are given much importance as they are
mostly useful in predicting accurately, the movements of the
market.
• Most of the beginners tend to ignore the importance of "when to
trade" in the market.
• The professional, expert and refined trader always appropriately
times his entry in the market in order to reap the maximum
benefits and make the most profitable deals.
• Limiting losses by analytically monitoring the market gives a
trader a more prospective outlook.
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THANK YOU
Rajat Prasad
Certified Treasury Professional
rajatprasad@gmail.com

Foreign exchange arithmetic

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