FOREIGN EXCHANGE

With the most busy month of March getting finally over, its time to relax and spend time with your family and go out on a vacation. And if at all you are planning a trip to abroad you might want to do shopping there. What will be the basics you will be doing before going ?

Foreign Currency, yes that’s the most important component of your trip to abroad.

It all started with the failure of Barter system in encouraging trade that currencies came into existence and every country having its own currency to trade. And it is because of this difference in currencies of different nations that the concept of foreign exchange came into existence.

In commodity market you value the items that you purchase in money terms. But in foreign exchange you value money in terms of money but both are of different countries having different currencies. What is foreign exchange? It is the amount of home currency you give to exchange it for foreign exchange.

Foreign Exchange market in short is also called FOREX. It is the most traded financial market in the world. Every trading day over $4 trillion worth of currencies are traded across the world buy Banks, financial institutions and individual investors. The trading week begins from Monday morning in Sydney, Australia and finally closes on Friday evening in New York. There is no central market for currency trading which thus provides the investors with an opportunity to invest 24 hrs a day for a period of 5 days in a week

 In India the forex market is divided into two layers.

Layer 1

This layer consists of the main controllers of forex in India. RBI is the chief regulator of forex in India, along with that FEDAI (foreign exchange dealer’s associations of India) also plays a vital part in making of the rules for the same.

Layer 2

This layer consists of Bank-to-Bank (interbank) and Bank-to-customer(merchant transaction) transactions.

Why do people buy foreign currency?

1. To purchase the items abroad (  e.g. Tourists )
2. For FDI (Foreign Direct Investments )
3. For Gaining  ( By the fluctuations in foreign currency rate )
4. For paying for imports.

How to interpret Forex quotes?

In Foreign exchange market currencies are always traded in pairs that’s because we exchange one country’s currency for another therefore whenever we buy a foreign currency we are simultaneously selling our home currency.

Forex quotes consists of two prices

1. The price at which we can buy the foreign currency (also called as “ASK PRICE” )
2. The price at which we can sell the foreign currency (also called as “BID PRICE” )

ASK PRICE is the price at which the bank is ready to sell us the foreign currency and the BID PRICE is the one at which the bank is ready to buy the foreign currency from us .

Ask price is always greater than Bid price as we are the customers and bank/dealer is the provider therefore we will always buy at the highest of the quote that is the ASK PRICE and sell at the lowest of the quote that is the BID PRICE or put it the other way bank always sells at the highest of the quotes and buys at the lowest of the quotes.

You might have read the foreign currency rates that appear in the daily newspaper in the format as follows

USD/INR

The currency that is placed first is called as the base currency and the other one is called as the     price currency.

So as per the above quote dollar is the base currency and rupee is the price currency

e.g. suppose that the rate quoted by the bank to you is given is in the following form

       USD/ INR = 45.20/45.22

The above given quote is referred to as a two way quote.

This implies that US dollar is the base currency and rupee is the price currency and that the bank is ready to buy dollar from you at the BID PRICE (45.20) and is ready to sell you dollar at the ASK PRICE (45.22)

NOTE: Bid Price is always smaller than Ask price.

Sometimes rate is also given as

Rs / $

In this case the currency at the first position is called as the price currency and the other one is called as the base currency. Hence, Rs is the price currency and $ is the base currency respectively.

e.g. suppose the rate given is

        Rs 45.20 / $

This though is an outdated form of a quotation but implies that for 1 dollar we will have to pay Rs 45.20.

The party that gives the quote is called as the MARKET MAKER

And, the party which takes the quote is called as the MARKET USER

What is the difference between BID RATE and ASK RATE called as?

This difference between bid rate and ask rate is called as ‘SPREAD’

What is Exchange Margin?

Exchange Margin also called EM is the margin that the Market maker earns when we do a transaction with him or her. 

How is the quote decided in case of Bank-to-Customer transaction?

When a customer approaches a bank to buy foreign currency then the bank has to provide him with a quote. For this the bank first checks the quote which is available in the interbank market for its purpose and then adjusts exchange margin in it before giving a quote to the customer. The main activity carried out here is that when a bank buys foreign currency from a customer, it will sell it in the Interbank (IB) market (this is called as squaring off of merchant transaction).

In this way merchant rate is calculated and user bank profit is confirmed in the form of ‘EM’( Exchange Margin) 

e.g. Suppose IB quote is         1 $ =  45.30/45.33 Rs

And you approach your bank to sell 1 $

What should be the quote given buy the bank if it wants to earn 5 paisa profit on the transaction

ANS

Since the bank will buy dollar from you therefore the relevant rate is the lowest of the quote that is 45.30.

Now the bank will adjust its EM in this quote. Now since 45.30 is the price that bank will pay you and will receive the same when it will square off therefore to earn a margin the bank will have to pay you less so it will deduct the margin of 5 paisa from the quote i.e.

For you the quote will be  =  45.30 - .05 = Rs 45.25

   

Hence, the bank will buy from you at Rs 45.25

Similarly in case you want to buy dollar from the bank the calculation will be as foolows

Relevant rate = highest of the quote =  45.33

ADD : EM                                         = 00.05

Total that will be quoted to you         = 45.38

Hence, the bank will sell you at Rs 45.38.

And this is how my friends you get the desired currency

I hope that now you all must have known how the entire things are carried out in foreign exchange.

So next time when you plan a trip to abroad you will be knowing everything that actually takes place when you get your currency converted.


This article has been Authored by RISHABH AHUJA. He can be contacted at: simply_rishabh@yahoo.com