Foreign Exchange Rates: Spot, Forward, and Cross Rates, Study notes of Business Administration

Download Foreign Exchange Rates: Spot, Forward, and Cross Rates and more Study notes Business Administration in PDF only on Docsity! SPOT AND FORWARD TRANSACTIONS: In foreign exchange transactions the transactions are not completed on the same date. The actual exchange of currencies may take place at different time periods For instance let us suppose that there are two banks in the foreign exchange transaction. Bank of India agrees to buy from Bank of Baroda, British pounds one lakh. The actual exchange may take place (1) on the same day or (2) two days later or (3) Some day late say after a month. In case 1.where the agreement to buy and sell is agreed upon and executed on the same date, the transaction is known as ‗cash transaction‘. It is also known as ‗value today‘. In case 2, if the settlement takes place, within two days, the rate of exchange effective for the transaction is known as spot rate. In case 3, while the delivery and payment takes place after a month, then the transaction in which the exchange of currencies takes place at a specified future date is known as forward transaction. The forward transaction is an agreement between two parties requiring the delivery of some specified future date of a specified amount of foreign currency by one of the parties against payment in domestic currency by the other party at the price agreed upon in the contract. The rate of exchange applicable to the forward contract is called the forward exchange rate and the market for forward transaction is known as forward market. Cross Rates: A cross rate may be defined as an exchange rate which is calculated from two (or more) other rates. Thus the rate for the Deutschmark to the Swedish crone will be derived as the cross rate from the US dollar to the Deutschmark and the US dollar to the crone. The practice in world foreign exchange market is that currencies are quoted against the US dollar. If one bank asks another bank for its Deutschmark rate, that rate will be quoted against the US dollar unless otherwise specified. Most dealings are done against the US dollar hence it follows that the market rate for a currency at any moment is most accurately reflected in its exchange rate against the US dollar. A bank that was asked to quote sterling against the Swiss franc would normally do so by calculating this rate from the sterling/dollar rate and the dollar/Swiss franc rate. Thus, the cross rates would be used to determine the quotations. Exchange quotations in international markets: With a few exceptions, in the international markets, all rates are quoted in against US dollar. For instance, at Singapore Swiss Franc may be quoted at 1.5425/5440 and Japanese Yen at 104.67/70. This should be understood as: USD 1 = CHF 1.5425 – 1.5440 USD 1 = JPY 104.67 – 104.70 While interpreting an international market quotation, we may do that either from the variable currency or the standard currency, viz., the dollar. In the above quotation, in which Swiss Francs are received in exchange for dollars as: (a) purchase of Swiss Francs against Dollar or (b) sale of Dollar against Swiss Francs. For the sake of uniformity we will assume the standard currency as the currency being bought or sold. The quotation for Swiss Franc is CHF 1.5425 and CHF 1.5440 per Dollar. While buying dollar the quoting bank would part with fewer francs per dollar and while selling dollars would require as many francs as possible. Thus CHF1.5425 is the dollar buying rate and CHF1.5440 is the dollar selling rate. It may be observed that when viewed from dollar the exchange quotation partakes the character of a direct quotation and the maxim ‗Buy low; Sell high‘ is applicable. We will denote such rates as ‗Dollar/Foreign Currency Rates‘, implying that dollar is being bought or sold against foreign currency. Few currencies such as pound sterling and Euro are quoted in variable units of USD. They are quoted as so many US dollars per unit of foreign currency concerned. The standard currency here is the foreign currency and will indicate such quotation as ‗Foreign Currency/Dollar Rate‘, the quotation for buying and selling of foreign currency against dollars. Forward Margin/Swap Points Dollar/Foreign Currency Quotation At Singapore market dollar may be quoted against Swiss franc and Japanese yen as follows: Swiss Franc Japanese Yen Spot 1.5425/40 104.67/70 1 month forward 50/60 17/16 2 months forward 70/80 30/29 The forward margin (also called swap margin or swap points) is quoted in terms of points and a point is the last decimal place in the exchange quotation. It could be in a four digit quotation, a point is 0.0001 or in a two decimal quotation like 0.01. If the forward margin is ascending order then forward margin is at premium. Premium is added to the spot rate to arrive at the forward rates, both in respect of purchase and sale transactions. The forward margin is given in descending order then forward margin is at discount and deducted from the spot rate to arrive at the forward buying and selling rate. Using the information already available, the forward rates for dollar against Swiss franc are arrived at as follows: Dollar Dollar Buying Selling 1 month forward CHF 1.5475 1.5500 2 months forward CHF 1.5495 1.5520 As against Japanese Yen, the forward dollar is at a discount, i.e., the forward margin is in descending order. Therefore, discount is deducted from the spot rate to arrive at the forward rate, both for buying and selling. The forward rates for dollar against, Japanese Yen based on the data already given are as follows: 1 month forward Dollar Buying JPY 104.50 Dollar Selling 104.54 2 months forward JPY 104.37 104.41 Foreign Currency / Dollar Quotation Let us assume the following exchange rates are prevailing: Spot Pound Sterling 1.4326/48 Euro 1.0325/35 1 month forward 50/53 65/62 2 months forward 90/93 84/82 Example: The forward margin can be calculated for a specific period given the spot rate and interest differential. Let the spot rate and interest rate differential are as follows: Spot rate $1=Deutschmark 1.5000 and the interest rate differential is equal to 8 per cent(US 3.5% and DEM 11.5%).Let us also assume that the no. of days in a year to be 360 days and the forward margin is for a period of 180 days or 6 months. The forward margin therefore is Forward period X Interest Differential X Spot rate Forward Margin = 100x No. of days in the year 180 x 8 x 1.5000 = 100 x 360 The Forward margin for 180 days = 0.0600. The forward rate is obtained by adding the forward margin to spot rate. Forward rate is equal to Spot rate plus or minus forward margin. Forward Quotations: The forward quotations for a currency will be quoted with the following information viz., the spot rate and the forward margin. Given this the forward rate has to be calculated by loading the forward margin into the spot rate. Example: On 25th January in the Inter bank market the US dollar is quoted as follows: Spot US$1=Rs. 42.4000/2100 Spot/February 2000/2100 Spot/March 3500/3600 In the above quotation, the first statement is the spot rate for dollars, the first the buying rate Rs.42.4000 and the second Rs.42.4200 the selling rate while the one given as spot February and spot March are forward margins for the above moths respectively. The margin is expressed in a point that is 0.0001 of the currency. Therefore, the forward margin for February is 20 paise and 21 paise. Under direct quotation, the first rate in the spot quotation is for buying and second for selling foreign currency. Correspondingly, in the forward margin, the first rates relate to buying and second the selling. Taking spot/ February as example, the margin of 20 paise is for purchase and 21 paise for sale for foreign currency. Where the forward margin for a month is given in ascending order, it indicates that the forward currency is at premium. The outright forward rates arrived at by adding the forward margin to the spot rates. Example: Buying rate Selling rate February March February March Spot rate 42.4000 42.4000 42.4200 42.4200 Add: Premium 0.2000 0.3500 0.2100 0.3600 Forward rates 42.6000 42.7500 42.6300 42.7800 Now we got from the above calculation the outright rates. Buying selling Spot delivery USD 1 = Rs.42.4000 42.4200 Forward delivery February 42.6000 42.6300 Forward delivery March 42.7500 42.7800 On the other hand if forward currency is at discount the quotation will be indicated by quoting the forward margin in the descending order. For instance if the quotation for inter bank market for pound sterling on 20th April as follows: Spot GBP 1 = Rs. 68.4000/4300 Spot/May 3800/3600 Spot/June 5700/5400 In this example the forward margin is in descending order (3800/3600) then the forward sterling rate would be at discount. The forward rates can be calculated as follows: Ex: Buying rate Selling rate May June May June Spot rate 68.4000 68.4000 68.4300 68.4300 Less discount 0.3800 0.5700 0.3600 0.5400 Forward rates 68.0200 67.8300 68.0700 67.8900 would be at discount. Conversely if the rate of interest at the foreign centre is lower than that at the home centre, the forward margin would be at premium. This can be explained as follows: When the bank enters into a forward sale contract with the customer it arranges for delivery of the foreign currency on the due date by keeping the funds in deposit at the foreign centre concerned. If the interest rate is higher at the foreign centre concerned, the net gain to the bank is passed on the customer by offering the forward rate at a discount. If the interest rate is lower at the foreign centre, the bank suffers a net loss and the loss is passed on to the customer by quoting, the forward rate at a premium Demand and Supply: The demand for and supply of foreign currency to a very great extent determines the forward margin. In the foreign exchange market if the demand for foreign currency is more than its supply, forward rate would at premium. On the other hand if the supply exceeds the demand then the forward rate would be at discount. Profit motivated investors who want to gain out of the interest rate may try to borrow from low interest centre and invest in high interest centre. For example the investor may borrow at New York at (6%) and invest in Mumbai at (12%). In order to secure his position he may try to cover the transaction in the forward market. Then he will sell spot dollar and buy forward dollar. When many such investors do this with the intension of booking profit in the market, then the supply of spot dollar increases and pushes the price upwards. Thus the difference between spot and forward rate widens. The force of demand and supply may take the premium on forward even beyond the limit set by interest differential. Therefore, it is not just interest differential alone that determines the forward margin. Sometimes it may also be stated that the loss on account of this premium may exceed the gain on account of interest differential on the investment. In that case there is no point in carrying out the plan of investment. Speculation about Spot Rates: The spot rates form the basis for determining forward rates. And therefore, any speculation about spot rates would influence forward rates also. If the exchange dealers anticipate the spot rate to appreciate, the forward rate would be quoted at premium. If they expect the spot rate to depreciate, the forward rate would be quoted at a discount. Exchange Regulations: Exchange control regulations enforced by the governments of the nations also influences the forward margin. And these regulations may put some conditions on the forward dealings and may obstruct the influence of the other factors on the forward margin. Such restrictions may include keeping of balances abroad, borrowing overseas etc. Intervention in the forward market by the central bank may also be done to influence the forward margin. Summary and Conclusions: In this chapter we have understood the meaning of foreign exchange, foreign exchange rate and foreign exchange market. We have also discussed the basics of foreign exchange transactions – direct and indirect quotations, spot, forward