The document discusses various aspects of foreign exchange rates including: 1. Exchange rates are the ratio between two currencies and are quoted regularly in publications. Major world currencies include the USD, Euro, Yen, GBP, etc. 2. Exchange rates can be quoted directly or indirectly. Direct quotes place the domestic currency first while indirect quotes place it second. 3. Spot exchange rates are determined by the interplay of demand and supply forces in the foreign exchange market. Factors like the balance of payments, inflation, interest rates, and others influence spot rates.

1. ECHANGE RATEMECHANISM
In a foreign exchange market where different currencies are bought and sold, it is essential to
know the ratio between different currencies, how many units of one currency well equal one
unit of another currency.The ratio between two currencies is known as an exchange rate. The
various exchange rates are regularly quoted in newspapers and periodicals.
Major currencies in the world:
USD, EURO, YEN, GBP, CAN$, SWISS FRANC, AUS $
There are two methods for quoting exchange rates.
1.Direct quote
2.Indirect quote
Direct quote:
A direct quote gives the home currency price of a certain amount of foreign currency usually
one or 100units. If India quotes the exchange rate between the rupee and the us dollar in a
direct way the quotation will be written as
Rs.35/US$. Direct quote places domestic currency on the numerator of the quote.
Indirect Quote:
In the indirect quoting the value of one unit of home currency is presented in terms
of foreign currency. If India adopts indirect quotation, the banks in India will quote the
exchange n rate as us$ 0.2857/Re. indirect quote domestic currency placed in denominator.
Buying and selling rates:
Normally, two rates are published one being the buying rate and the other the selling rate.
The buying rate is also known as the bid rate. The selling rate is known as the ask rate or
offer rate. Bid rate always given first, followed by the ask rate quote. Buying quote of a
currency denotes the rate at which banks buy it.
Selling quote at which banks sell it. The banks need to make profit in these transactions, the
selling quote is higher than the buying the rate. The difference between these two quotes
forms the bank profit and is known as the spread.
Spread = (Ask price-Bid price)/Ask price*100
Forward market quotation:
The quotes for the forward market are also published in the newspapers and periodicals. The
quoting rates may be expressed as outright quotes, or as swap quotes. The outright quote for the US dollar
in terms of the rupee can be written for different periods of forward contract as follows.
Spot one month three monthRs.40.00-40.30 Rs. 39.80-40.20 Rs. 39.60-40.10
The swap quote on the other hand expresses only the difference between the spot quote and
the forward quote. It can be written as follows.
Spot one month three monthRs.40.00-30 Rs. (20)-(10) Rs. (40)-(20)
Forward premium and discount:
The forward rates have longer maturity, the spread too gets wider. This is because
of uncertainty in the future that increases with lengthening of maturity. The changes in
forward rates may be upward ordownwards.
Such movements arise between spot and forward rates. This is known as the swap or forward
rate differential. If the forward rate is lower than the spot rate, it well is a case of forward
discount. If the forward rate is higher than the spot rate it would be known as forward
premium. Forward premium or discount is expressed as an annualized percentage deviation

2. from the spot rate. It is computed as follows. Forward Premium (Discount) = (n-day forward
rate spot rate)/spot rate * 360/n
Cross rates:
The value of currency in terms of another one is not known directly. In such cases one
currency is sold for a common currency and again the common currency is exchanged for the
desired currency. This is known as cross rate trading and the rate established between the two
currencies is known as the cross rate.
Spot cross rate:
The selling rate of the Canadian dollar in Indian can be worked out by selling the rupee for the
US dollar at Rs.35.20/US $ and then buying Canadian dollar with the US dollar at C$0.76/US$
.Rs.35.20/US$1*US$ 1/C$0.76=Rs.46.32/C$
Forward Cross Rate:
The selling rate of one currency is divided by the buying rate of another currency and vice
versa. One month forward rate in case of the two currencies is
Rs.34.50-34.80/US$ and C$ 0.79-0.83/
US$. The forward rate of the Canadian dollar in terms of the rupee can be found as: Rs.
34.80/C$ 0.79 = Rs.44.05/C$Rs. 34.50/C$0.83=Rs. 41.57
By combining the two we get Rs. 41.57-44.05/C$
NOMINAL, REAL AND EFFECTIVE EXCHANGE RATE:
Nominal exchange rates are also called bilateral exchange rates. It represents the ratio
between the values of two currencies at a particular point of time.
Real exchange rates other hand is the price adjusted nominal exchange rate. The relationship
between nominal exchange rate, e and the real exchange rate, er can be written in the form.
Er = eP/P*W
here p and p* are domestic and foreign price indices. It is possible that the Indian rupee tends
to depreciate against US dollar but it appreciates against Japanese Yen. It is also possible that
rupee depreciates vis-à-vis different currencies at different rates. so it is essential to develop
an index or a summary measure of how rupee fares, on an average, in the foreign exchange
market.
Such an index is called an effective exchange rate. Effective exchange rate is the measure of
the average value of a currency relative to two or more currencies normally shown in the
form of indices.
DETERMINATION OF EXCHANGE RATE IN THE SPOT MARKET
The exchange rate between two currencies in a floating rate regime is determined by the
interplay of demand and supply forces. The exchange rate between say the rupee and the
US dollar depends upon the demand for the US dollar and its availability or supply in the Indian
foreign exchange rate. The demand for foreign currency comes from individuals and firms
who have to make payments in foreign currency mostly on account of import of goods and
services and purchase of securities. The supply of foreign exchange results from the receipt
of foreign currencies normally on account of export or sale of financial securities to foreign
entities.

3. Main Factors for Determining Spot Exchange Rates | Foreign Exchange
Some factors which affect the exchange rates are as follows:- 1. Balance of Payments 2.
Inflation 3. Interest Rates 4. Money Supply 5. National Income 6. Resource Discoveries 7.
Capital Movements 8. Political Factors 9. Psychological Factors and Speculation.
Factor # 1. Balance of Payments:
Balance of payments is a statement which shows the total demand and supply of a foreign
currency which helps in determining the value of the currency. Various exports (whether of
goods or services) and the imports, affect the balance of payment continuously.
Factor # 2. Inflation:
Inflationrate meanstherate at which the costof living of peopleofa country is increasing. Putting
it in different words, the inflation rate depicts the rates at which the cost of various goods and
services under its scope are increasing. The case where they are reducing it is known as deflation.
The relative changes in the inflation rates of different countries results into different value of the
local or domestic currency.This results into different exchange rates. Suppose, in India
inflation is at 10%, and in USA is at 3%, then the prices of goods and services would be
higher in India, in comparison to USA. Thus, the rupee is a weaker currency in comparison
to US $. Thus, the value of rupee will depreciate in relation to USA. Thus, the inflation rate
across the countries of the globe influences the exchange rates.
Factor # 3. Interest Rates:
The interest rates on various deposits and on loans are different across the countries of the
globe. This is due to the economics concept of demand and supply. If the capital is available
in abundance in a country, then the rate offered on deposits will be low. And if the
requirement of capital is more than its supply, the rates of which loans will be given will be
high. Now if the capital is scarcely available then the rate of the deposits will be higher, so as
to attract more deposits. And if the requirement of capital is less than its supply, then the rates
on which loans will be given will be low, to encourage people to take more loans. Now due to
change in interest rates among different countries, and supply and demand of capital differs
from a country to another in the globe, they exists some difference in their value. Thus, the
money, which is in a country where supply is low, the interest rates offered, will be more.
Thus, its currency will value more than the countries where the capital supply is more.
Factor # 4. Money Supply:
The total money quantum available in a country during a period is known as money supply.
The money supply shows the total money available in an economy during a period, which
helps in determining the rates of interest, inflation, etc.
Increase in money supply, is normally taken as increase in spare money in the country. The
money supply increase with increase in domestic production and service capacity of the
country. This results into increase in spending on foreign goods and purchase of foreign
investments.
Because with increase in money supply, the interest rate decreases; thus the investors are
tempted to invest in other countries where interest rates are higher. This results into excess
supply of money getting transferred to other countries. Due to this the value of currency

4. reduces in foreign market, and results into increase in value of imports. This in turn results
into increase in inflation rate.
Factor # 5. National Income:
National income shows the total income of the residents of an economy. The increase in
national income results into increase in supply of money and in turn results into increase in
production or creation of production capacities.
The increase in production results into increase in exports, directly or indirectly. The increase
in incomes of the residents of economy results into increase in imports. This in turn results
into dilution of the domestic currency of the country in the foreign exchange market. Thus, in
turn increase in inflation will also affect exchange rate
Factor # 6. Resource Discoveries:
When a country discovers resources, and starts exporting them, it results into their strong
position in exchange market. A good example can be of the oil, which plays a significant role
in foreign exchange market through its export and import in the International market, through
International Trade Thus, when the supply of oil, in raw or finished form from its major
suppliers, such as Middle East, becomes insecure, the demand of the currencies of this
countries increase.
Previous oil crisis favoured USA, Canada, UK and Norway and adversely affected the
currencies of oil-importing countries like Japan and Germany. Similarly, discovery of oil by
some countries helped their currencies to gain in value. The discovery of North Sea oil by
Britain helped pound-sterling to rise in foreign exchange market. Canadian dollar also
benefited from discoveries of oil and gas off the Canadian East Coast and the Arctic.
Factor # 7. Capital Movements:
Short-term movement of capital from one country to another is normally influenced by the
interest rates in a country. As seen in the discussion of interest rates, the country with higher
rate of interest will get more capital supply in comparison to the countries providing lower
rate of interest. If interest rate in a country rises due to change in various key indicators of
economy and policies of the country, there will be a flow of short-term funds into that
country and the exchange rate of the currency will increase in the foreign exchange market.
Reverse will happen in case of fall in interest rates.
If there is increase in the interest rate of the country and other factors remains constant, the
foreign investment in that country will see an upward trend, thus leading it to a strong
position in the foreign exchange market. Reverse will happen in a country where there is
decrease in the interest rate, and the upward trend will not be as high as said above, if the
other factors don’t remain constant.
The external borrowing and assistance in various ways will result into a favourable effect on
the exchange rate of the country. But, when the repatriation of principal with interest is done
or started the exchange rate will move in opposite direction.
Factor # 8. Political Factors:
The look out of government towards the foreign market and international trade and
commerce define their policies. A steady government of a country provides more time to
investors of different countries to decide their strategies and take steps of investing.

5. The turbulence in government of a country will affect the investors of different countries, and
might reduce the overall foreign investment in the country. Thus, the policy of a country
decides the ratio and proportion of the foreign investment in the country.
The policy of the government depends on the economic situation in an economy. For
Example, if a country is moving with deficit in balance of payments and lower inflation rate
(some rate of inflation is required in a country to sustain itself), the government will take
measures to increase the exports, decreasing the imports, calling for foreign capital and in –
built capital creation, etc.
The pattern which government decides to follow will result into creation of that kind of
policies, thus will provide an idea to foreign investors, that what a government of a country is
planning and how the economy of a country is proceeding. Government will initiate various
steps in like intervening in the market, if there is wide variation between the market rates
from predetermined rate.
Factor # 9. Psychological Factors and Speculation:
The perception and speculative motives in the mind of an individual player or firm will play a
significant role in the movement of prices of the foreign currency.
Many a times, the market maker in the market can influence the rate, to move differently
from that determined by long-term economic forces, by buying or selling a particular foreign
currency or group of freeing currency on large scale and conversion to take place
immediately from one currency to another.
A large-scale purchase or sale of foreign exchange by speculators with expectation of fall or
rise in exchange rates in addition to change in the interest rates or taking the support of
capital account convertibility, accelerates the fall or rise in the foreign exchange conversion
rate.
The speculator may purchase heavily a foreign currency by expecting a rise in price (known
as bull player) or sell heavily by assuming future fall in prices (known as bear). The
speculator may also rake the form of leads (pre or early) and lags (post or delay) in delivery
of foreign currency, with an intention to gain benefits of the price movements.
The exchange rates are influenced by numerous factors. Some are interrelated while some are
independent. Factors together decide the trend.
DETERMINATION OF EXCHANGE RATE IN THE FORWARD MARKET
Forward exchange rate is normally not equal to the spot rate. The size of forward premium
ordiscount depends mainly on the current expectation of future events. The determination
of exchange rate in a forward market finds an important place in the theory of interest rate
parity (IRP). Covered interest rate Arbitrage,Uncovered interest rate arbitrage.
Main Factors Affecting the Forward Rate Mechanism
Factor # 1. FCNR Deposits and the Forward Rate:
Under the Foreign Currency Non-residents (FCNR-B) deposit scheme, banks can swap
foreign currency deposits for rupees in the market. (Under an earlier FCNR-A scheme, now

6. discontinued, such swaps were done with RBI, at level rates). Swap is a kind of transaction
which banks enters, to hedge their position of foreign exchange.
They are always in a position in foreign exchange market viz. over-bought or over-sold. The
banker who is in over-bought position will need to provide home currency on the exchange
date.
Thus, he will need to arrange for requisite home currency to get foreign currency. To hedge
his position to the variations in the foreign exchange market, he will also need to sell foreign
currencies; else he will have lots of foreign currency but no home currency to pay for it.
So when he sells foreign currency he hedges his position through availability of home
currency and can maintain his profits through the continuous changes happening in foreign
exchange market.
Bank also faces the same type of problems, with respect to interest amount receivables and
payables with respect to foreign currency. If the interest amount is not hedged in the forward
market, strictly speaking, it should be included in the “gap” limit referred to above.
A bank would swap FCNR deposits for rupees in the manner indicated, only if the overall
cost of generating the rupee resources is economic, i.e., when the forward margin is less than
the interest differentials between foreign currencies and rupees. Thus, the deposited banks are
also a source of demand in the forward market.
Factor # 2. Forward Margin:
The forward margin depends on the perceptions of the buyers and sellers of currencies in the
Indian market. The forward margin is called a premium on the currency whose forward rate is
costlier than the spot rate and a discount where the forward rate is cheaper. It is expressed in
the same currency as the spot rate and the general practice is to quote it as a discount or
premium on that i.e., reported currency.
Factor # 3. Delivery Options:
Delivery option refers to the option for choosing the value date within an agreed period. In
the interbank market, the option period may be limited to the extent of a calendar month, and
can be further broken down based on the need of the party, by considering the actual date of
need.
One feature of the Indian market is that the delivery of a claim for foreign currency
receivable is considered as delivery of the foreign currency although the currency may be
receivable after some time.
For example, if a bank buys from an exporter a dollar bill of exchange drawn on the buyer
abroad, the exchange transaction, namely the purchase of dollars, is completed when the bill
itself is purchased. It will be readily seen that the bank would actually get the dollars only
when the buyer abroad will pay the bill in accordance with its tenor of maturity.
When the agreed value date for the transaction is in mid of the month, then the accepted
standard rule for rate quotations for option contracts is the worse rate among the beginning
and end of the option period, and is use by bank to quote to the customer.

7. It means that if a foreign currency is at a premium in the forward market, then the rate
applicable to the beginning of the option period will be quoted and used by bank for purchase
of the foreign currency from the trader or merchant. But, if the bank has to sell the foreign
currency the rate applicable at the end of the period will be applicable. This is done with a
specific reason to gain to be earned by banker.
If the foreign currency is at a discount the worse rate rule will be to load the highest discount
in the purchase rate, and the lowest in the sale rate.
In brief, for option forwards,
The basic principle for quoting a forward rate to the customer is the same as for spot rates, to
ascertain the wholesale market rate and add a load of margin. If the interbank spot rate is
Rs.42.53/56 and the one month discount on the rupee (i.e. premium on the dollar) is 5/6 ps,
the wholesale market rates for one month forward dollars are Rs.42.58/62.
The one month option forward customer rates, assuming a margin of 10 p, will be selling, or
offering, dollars (to importers, etc.) at Rs.42.72, and buying, or bidding for dollars (from
exporters, etc.) at Rs.42.48. The one month fixed date delivery rates will be Rs.42.48/42.72.
Factor # 4. Card Rates for Customer Transactions:
Banks in India have either a central interbank trading office for foreign exchange operations
(the FX Treasury), or at best can have offices in two or three major centers. The customer
transactions are undertaken at a large number of branches. The practice therefore is to
calculate the so-called “card rates” for customer transactions in the FX treasury in the
morning, based on the ruling rates in the domestic and international markets.
The card rates are then communicated to the operating branches by telephone or fax or e-mail
etc. The card rates are used for undertaking customer transactions for amounts not exceeding
a stipulated limit. Generally, the card rates are for relatively small value transactions, and are
difficult to change intra-day.
Card rate includes the maximum permissible margins. For large value transactions, i.e.,
beyond the stipulated limits, the branches are expected to telephone the FX treasury and get
applicable rate. In general, these would be more competitive, and based on the ruling
interbank rates.
Factor # 5. Interbank Forward Quotations:
These quotations are in paisa per dollar or any other foreign currency and apply to end of the
month deliveries. The interbank market is not active beyond 12 months. The interbank
forward quotations are quotes used and applied for transactions between two banks to ensure
to remove the mismatch of maturities in their forward transactions.
Factor # 6. Cash: Spot and Call Rates:
The cash spot margin in the interbank market is generally governed by the call market in
Indian rupees. This is because arbitrage is possible between borrowings in the call market at a
particular rate, and sells cash or buy spot dollar swap in the exchange market. Banks would
use the cheaper market; hence, there is a strong correlation between the cash: spot margin and
the call rate.