In the last two posts we read about the various aspects of International trade, including Balance of Payment. As we have read international trading comprises of countries buying and selling goods and services from and to each other or investing capital or repatriating funds across borders. These international transactions are carried out in foreign currencies and therefore to effect their transactions countries and their individuals buy and sell currencies in the foreign exchange markets daily day in and day out. The foreign exchange market is a 24 * 7 market and trading volume in the foreign exchange market according to the Bank for International Settlements is to the tune of $5.3 trillion a day. Currencies are traded at market determined currency exchange rates, which move with the demand and supply for each currency. So today lets begin our discussion by understanding the basics of the foreign exchange market.
Currency exchange rate
A currency exchange rate is the price of one currency in terms of another currency. For example if the exchange rate between USD and INR is stated as 1US $ = 68 INR, we are saying the cost of per US dollar is 68 Indian Rupees, i.e. one US dollar can be purchased with 68 INR. This quotation is generally written as 68 INR/USD i.e. 68 INR per USD. Here USD is the base currency as the quotation is expressed in per unit of USD. INR is the price currency.
Direct and indirect currency exchange rate
A currency exchange rate generally involves two currencies, one domestic and one foreign. A currency exchange rate quotation can be either direct or indirect. A direct quote is where the domestic currency is expressed in terms of per unit of foreign currency. In a direct quote therefore the foreign currency is the base currency and the domestic currency is the price currency. For example in India if the Dollar-INR currency exchange rate is quoted as 68 INR/USD it is a direct quote.
On the other hand, in an indirect quote the foreign currency is expressed in terms of per unit of domestic currency. Here the domestic currency is the base currency and the foreign currency is the price currency. For example if the Dollar –INR currency exchange rate in India is expressed as 0.0147 USD/INR, it is an indirect quote.
The currency exchange rate for most major currencies is generally expressed up to four decimal places except for currency exchange rates involving the Japanese Yen which is expressed up to two decimal places.
Cross currency exchange rate
A currency exchange rate between two currencies which is implied by their exchange rates with a third common currency is called as a cross currency exchange rate. A cross currency rate comes into play when there is no quote available in the market for a currency pair i.e. the currency pair is not generally traded and the quote for the currency pair needs to be derived from their exchange rates with a third common currency.
For example, the AUD – NZD is not a regularly traded pair. However the AUD/USD and NZD/USD are frequently traded pairs. If the exchange rate between AUD – USD is 1.32 AUD/USD and NZD – USD is 1.39 NZD/USD then 1.32 AUD should be equal to 1.39 NZD. Therefore the quote for AUD – NZD can be derived as 1.39/1.32 i.e. 1.053 NZD/AUD. Note here that both the quotes were direct quotes therefore we have divided them. Had one quote been a direct quote and the other an indirect quote, then we would have had to multiply them to arrive at the cross currency rate.
In our example the base currency in the cross currency quote is AUD. There is no rule as to which currency should be the base currency in a cross currency exchange rate, however the stronger currency is generally taken as the base currency.
Spot and forward currency exchange rate
When a currency deal is struck at a particular exchange rate the parties to the deal agree to exchange one currency for the other at the agreed exchange rate. A spot exchange rate is the currency exchange rate for delivery two days after the trade date. Similarly forward exchange rate is the currency exchange rate for delivery at a future date at an exchange rate decided upon today. Forward quotations are available for many forward dates like 30 days, 60 days, 90 days and 1 year. By getting into a forward trade a party can lock in an exchange rate at which currencies will be exchanged at a future date and therefore remove all price uncertainty.
For example an Indian importer has to make a payment for goods imported from the USA in US Dollars 30 days from now. Therefore he will need USDs 30 days from now to pay for the goods. Today the USD – INR rate is 68 INR/USD. He is not sure where the rate will be in 30 days time. If the INR depreciates against the USD during the period he would have to shell out more Rupees per USD. Therefore to remove price uncertainty he can get into a forward trade today for buying USD against rupees 30 days from now at a forward exchange rate agreed upon today. Hence 30 days from now wherever the USD – INR rate maybe the importer is not affected by it as his rate is already locked in.
A forward currency exchange rate is typically expressed in terms of basis points over the spot exchange rate. One basis point is 1/10,000 i.e. 0.0001. If the forward quote is given as +11.53 it means the forward exchange rate is 11.53/10000 = 0.001153 basis points more than the spot currency exchange rate.
That’s all in this part of Currency exchange rate…………in the next post we will read about nominal and real exchange rates and exchange rate regimes among many other things….. if you want the post in your mailbox use the SUBSCRIBE options on the page and follow me by email….bye for now
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For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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