Unit III: Foreign Exchange Management

Structure of Forex Markets

The foreign exchange (forex) market is the global marketplace where currencies are bought and sold.

A. Wholesale Market (Interbank Market)

• Participants: Large banks, central banks, multinational companies, financial institutions.

Features:

• Very large transaction volumes.
• Highly liquid.
• Trades occur 24×7 across major financial centers.
• Prices are negotiated (OTC market).

B. Domestic (Retail) Forex Market

• Participants: Individuals, exporters & importers, tourists, NRIs, small firms.

They deal through:

• Banks
• Money changers
• Forex brokers

Key features:

• Smaller transaction sizes
• Rates include a margin (spread) charged by banks
• Used for remittances, travel, education, trade

Types of Forex Quotations

Forex quotations show the price of one currency in terms of another.

A. Direct Quotation

• Foreign currency is the base; home currency value changes.
• Formula: 1 unit of foreign currency = X units of home currency
• Example (India): USD 1 = INR 84.50 (direct quote in India)

B. Indirect Quotation

• Home currency is the base.
• Formula: 1 unit of home currency = X units of foreign currency
• Example (India): INR 1 = USD 0.0118 (indirect quote)

C. Cross Currency Quotation

Used when two currencies are not directly quoted against each other.

Example:
If

• 1 USD = ₹84.50
• 1 USD = ¥150

Then: ₹1 = (150 / 84.50) = ¥1.77 (cross rate)

Forex Transactions and Settlement Dates

A. Spot Transaction

• Purchase/sale of currency for immediate delivery.
• Settlement: T + 2 days (standard in global markets).

B. Forward Transaction

• A contract to buy/sell currency at a future date at a pre-decided rate.
• Settlement: beyond 2 business days.
• Used by importers/exporters to hedge risk.

C. Swap Transaction

A combination of:

• Spot + Forward or Forward + Forward

Example: Buy USD spot and sell USD forward (swap)., Used by banks/companies to manage liquidity.

D. Cash & Tom Transactions

• Cash: Same-day settlement.
• Tom (Tomorrow): Next-day settlement.

Forward Rates

Forward rate = Spot rate ± Forward premium/discount.

Forward Premium

When foreign currency is costlier in future. Forward rate > Spot rate

Forward Discount

When foreign currency is cheaper in future.
Forward rate < Spot rate

Formula for Forward Premium (%):

$$\text{Forward Premium (\%)} = \frac{\text{Forward Rate} - \text{Spot Rate}}{\text{Spot Rate}} \times \frac{12}{\text{Number of Months}} \times 100$$

Explanation 

• Forward Rate – Spot Rate → Difference between future price and today’s price
• Divide by Spot Rate → Converts it into percentage
• Multiply by 12/Months → Annualizes the premium
• Multiply by 100 → Converts to percent

Example

Spot Rate: ₹84.00/USD
3-Month Forward Rate: ₹85.20/USD

$$\frac{85.20 - 84}{84} \times \frac{12}{3} \times 100$$
$$= \frac{1.20}{84} \times 4 \times 100$$
$$=5.71\mathrm{\%}$$

Forward premium = 5.71% p.a.

Merchant Transaction Quotes

Rates quoted by banks to customers (not interbank).

Types:

1. TT Buying Rate – For inward remittances, export bills.
2. TT Selling Rate – For outward remittances.
3. Bill Buying Rate – When bank buys export bills from exporter.
4. Bill Selling Rate – When bank sells foreign currency to importer.

Merchant rates include:

• Exchange margin
• Forward premium
• Service charges

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Quick Summary Table

Topic	Key Points
Markets	Wholesale = large banks; Retail = customers, small firms
Quotations	Direct (1 foreign = X home), Indirect (1 home = X foreign), Cross (via third currency)
Transactions	Spot (T+2), Forward (>T+2), Swap (spot+forward), Cash/Tom
Forward Rates	Currency can be at premium or discount
Merchant Quotes	TT buy/sell, Bill buy/sell

Early Delivery, Extension, and Cancellation of Forward Contracts

Forward contracts are binding agreements between a bank and a customer. Sometimes customers need changes due to business circumstances.

A. Early Delivery (Pre-delivery)

When the customer wants currency before the maturity date.

Key Points

• Allowed by banks with conditions.

Bank will re-calculate the rate based on:

• Spot rate on the early delivery day,
• Adjusted forward premium/discount,
• Bank margin.
• Customer may gain or lose depending on market movement.

Example: Importer had a 3-month forward contract but shipment arrives early → needs USD early → early delivery allowed with revised rate.

B. Extension (Roll-over) of Forward Contract

When the customer does not want delivery on the maturity date and wants to extend the contract.

Process

1. Bank cancels the original forward contract (by applying the cancellation rate).
2. Any gain/loss is settled.
3. A new forward contract is booked for an extended period.

Cost to Customer

• Cancellation loss (if any),
• New forward premium,
• Bank charges.

Used by: Importers whose payments get delayed, exporters whose receipts are delayed.

C. Cancellation of Forward Contract

When the customer wants to terminate the contract before or on maturity.

Rules

• Bank cancels at the prevailing spot rate.
• Gain/loss is passed on to customer.
• If customer fails to use the forward contract on maturity → automatic cancellation.

Example

Forward booked at ₹84.00/USD
Spot on cancellation day = ₹82.00/USD
→ Customer pays loss of ₹2 per USD (because contract becomes disadvantageous).

Introduction to Cryptocurrencies in International Finance Context

Cryptocurrencies = digital currencies secured by blockchain technology.
Examples: Bitcoin, Ethereum, USDT, XRP.

Role in International Finance

• Cross-border Payments: Faster than SWIFT; lower cost.
• Digital Assets: Used as investment instruments by global investors.
• Hedging Tool: Some firms use crypto futures/options for hedging volatility.
• Stablecoins (USDT/USDC): Used for international settlements to reduce currency conversion costs.
• Alternative to Weak Currencies: In high-inflation countries, businesses hold crypto to preserve value.

Limitations

• High volatility (except stablecoins)
• Regulatory uncertainty
• Limited acceptability for trade
• Risk of money laundering and cyber fraud

Exchange Rate Determination and Forecasting

Two important theories: Purchasing Power Parity (PPP) and Interest Rate Parity (IRP).

A. Purchasing Power Parity (PPP)

PPP says:

Exchange rates adjust so that identical goods cost the same in different countries.

Formula (Relative PPP)

$$\frac{E_1-E_0}{E_0}\approx {\text{Inflation}}_{\text{home}}-{\text{Inflation}}_{\text{foreign}}$$

Where:

• $E_{}$0 = Current exchange rate
• E1= Future exchange rate

Interpretation

• If India’s inflation > USA’s inflation → Rupee will depreciate.
• If USA’s inflation > India → Rupee will appreciate.

Example:
Inflation India = 6%
Inflation USA = 2%
→ INR expected depreciation ≈ 4%

B. Interest Rate Parity (IRP)

IRP states:

Difference in interest rates between two countries equals the forward premium/discount in their currencies.

Formula

$$\frac{F-S}{S}=\frac{1+i_h}{1+i_f}-1$$

Where:

• $F$ = Forward rate

• $S$ = Spot rate

• $i_h$ = Home country interest rate

• $i_f$ = Foreign country interest rate

Interpretation

• If India’s interest rate > USA’s rate → INR will trade at forward discount.
• If USA’s rate > India → INR will be at forward premium.

IRP Example

Spot: ₹84/USD
Interest rate India = 8%
Interest rate USA = 4%

$$\frac{F - 84}{84} = \frac{1.08}{1.04} - 1 = 0.0385$$
$$F=84(1.0385)=\text{₹}87.23$$

→ Forward rate = ₹87.23/USD
→ INR at discount.

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Quick Summary Table

Concept	Meaning	Impact
Early Delivery	Take currency before maturity	Repricing based on spot + premium
Extension	Extend forward period	Cancel + new contract
Cancellation	Terminate forward contract	Gain/loss based on market
Crypto	Digital global currency	Cross-border payments, investment
PPP	Inflation difference determines exchange rate	High inflation → currency depreciates
IRP	Interest rate difference determines forward rate	High interest → forward discount