Foreign Exchange

1. What is a currency?
- Currency is a medium of exchange for goods and services. In other
words, it is money, in the form of paper or coins, usually issued by a
government and generally accepted at its face value as a method of
payment.

2. What is an exchange rate?

- An exchange rate is the rate at which one currency will be
exchanged for another currency.
- The exchange rate is also regarded as the value of one country's
currency in relation to another currency.
- For example, an interbank exchange rate of 85 Indian Rupees (INR)
to the United States dollar means that INR 85 will be exchanged for USD
1 or that USD 1 will be exchanged for INR 85.
 What is foreign exchange market?
- The foreign exchange market is the market where one
buys or sells the currency of country A with the currency of
country B.
- The purpose of such a market is to facilitate international
trade and investments.
- The need for a foreign exchange market arises because of
the presence of the different international currencies such as US-
dollar, UK-pound sterling, Europe-Euro, Japanese-Yen etc. and the
need for trading in such currencies.
- This market determines foreign exchange rates for every
currency.
- It includes all aspects of buying, selling and exchanging
currencies at current or determined prices.
- In terms of trading volume, it is by far the largest market
in the world.
• The activities of the foreign exchange market are
carried out mainly through the worldwide interbank
market.

• The trading is generally done by telephone, telex or

the SWIFT (Society for Worldwide Interbank Financial
Telecommunication) system. In addition, there are a
number of players who assist in trading of foreign
currencies.
 Who are the participants of Foreign Exchange Market?

• Corporates - A Corporate is an organization, usually a group of

people or a company authorized by the state to act as a single
entity (a legal entity recognized by private and public law) and
recognized in law for certain purposes. Corporates with
international business are susceptible to the exchange rate risk
and are a major player in the foreign exchange market.
• Commercial Banks -
• Exchange Brokers - A foreign exchange broker, also known as
an FX broker or a forex broker, buys and sells currencies on
behalf of clients while charging a commission for the service.
Foreign exchange brokers are ‘middlemen’ who match the
currency buy and sell orders from their clients to other client’s
orders.
• Central Bank -
• Borrowers - These are Corporates or Individuals
borrowing in foreign currency and exposed to the
exchange rate movement. These borrowers might or
might not have direct foreign exchange trade
transactions, but such borrowings will trigger a foreign
exchange risk which needs to be managed.

• Individuals - Individuals might be speculators acting

to take advantage of price movements or general
participation which takes place due to travel to
different countries.
What are the types of Foreign Exchange Transactions?

- Cash Transactions - In cases where the transaction to buy

and sell the foreign exchange takes place and actual
settlement is completed on that day itself, it is called cash
transaction.
Eg: 31st October 2021 Sell USD 1000 at 74 & receive
equivalent INR same day

- Tom Transactions - A tom transaction as the word suggests,

this means that the transaction done will be completed the
next working day.
Eg: 31st March 2025 Sell USD 1000 at 74 & receive
equivalent INR on T+1 day i.e. 1st April 2025
Spot Transactions
- A spot transaction in the foreign exchange market,
where in the settlement for foreign exchange is done
on 2nd business day.
- The quoted exchange rate in Foreign exchange
markets is by default the spot transaction.
- Eg: 31st March 2021 Sell USD 1000 at 74 & receive
equivalent INR after T+2 days i.e. 2nd April 2021
 What are the types of Foreign Exchange
Instruments?

• Forwards - The most prominent and widely used are

Over The Counter (OTC) “Forward Contracts” wherein
buyer and seller agree to exchange a pre-determined sum
of one currency against another at an agreed rate at a
future date, irrespective of what rate would be on that
future date.

• In a trade transaction, one of the parties to the contract

would invariably be a bank.
Eg: Participant enters into a forward contract on 31st
March 2021 to Buy USD 1000 (1 Lot) on 30th June 2021 at
a fixed rate of 73 irrespective of rate on 30th June 2021

• They are OTC contracts.

• Both the buyer and seller are committed to the contract.
• Forwards are price fixing in nature. Both the buyer and
seller of a forward contract are fixed to the price decided
upfront.
Futures - Futures are derivative instruments of standard size (Lot)
issued for a definitive period and price and are traded in an Exchange.

• While the price is based on an underlying asset, no delivery is taken

on the maturity date.
• The position is simply closed out any day up to the maturity date at
the ruling market rate and the difference between the contracted
price and the current ruling price is exchanged.
• Currency Exchanges provides good liquidity to manage the foreign
exchange risk and hence, it is also available as a risk management
tool.
• It would also facilitate easy to hedge, unhedge with transparent
pricing.
• However, there is a margin element and one needs to set aside some
funds to operate in futures exchange.
• The future transactions are also forward transactions and
deals with the contracts in the same manner as that of
normal forward transactions.

• However, the forward contracts are customized whereas

future transactions are standardized.

• Future contracts can be traded on the organized exchanges

only whereas forward contacts are private agreements.

• Also, an initial margin is required for the participants to

enter into a future contract which is not required for forward
contracts.
Eg:
Participant enters into a fixed date future contract on
31st March 2021 to buy of 1 lot (i.e. USD1000) on 30th
June 2021 on the exchange at 71.

On 30th June 2021, this transaction is cash settled i.e. if

the USDINR is at 72, participant will gain Rs 1000
(USD1000 * 1 (72-71)) and receive cash. If USDINR is at
70, participant will have to pay Rs 1000 (USD1000 * 1
(70-71)) and settle the transaction
 OPTIONS

• The foreign exchange option gives an investor the right,

but not the obligation to exchange the currency in one
denomination to another at an agreed exchange rate on
a pre-defined date.
• An option to buy the currency is called a Call Option,
while the option to sell the currency is called a Put
Option.
• Options are instruments of exchange very similar to a forward contract
in its form as it can be for any fixed amount at a price (strike price) even
different from the ruling market price and maturing on a future date.

• However, it differs from forward contract in that the buyer carries the
right to exercise the option but no obligation to honour.

• It also entails payment of a premium upfront by the buyer for this right.
The buyer pays the premium and the seller of the option (also called
writer) receives the premium.
• Buying an Option means a limited risk quantified as expense
by way of premium paid upfront for an unlimited opportunity
to make money should the underlying exposure (exchange
rate, interest rate, commodity/stock price) moves in the
direction anticipated.

• However, selling or writing an Option gives immediate

income by way of premium received but entails bearing an
unlimited risk of underlying exposure should it go the other
way.
• Options are mainly two types - Put and Call. A buyer of
‘Put’ has a right to sell the underlying asset at the
contracted rate. Conversely, a buyer of ‘Call’ has a right to
buy the underlying asset.
• A single contract of either a put or call option is also called
vanilla option, as it is a simple transaction. However, more
complex types of Option contracts (covered) are traded in
the market with a combination of both put and call
options. These are called Collars, Spreads, Straddles,
Strangles, Knock-out, Knock-in, etc. and each one is
distinguished by the strategy adopted.
• Of late, complicated structures are available in the
market, which present a different but mega event risk
scenario
Types of Foreign Exchange
Transactions
The transactions in the interbank market may place for settlement
• (a) on the same day; or
• (b) two days later; or
• (c) some day late; say after a month.

Where the agreement to buy and sell is agreed upon and executed
on the same date, the transaction is known as cash or ready
transaction. It is also known as value today.
• Transactions where the exchange of currencies takes
place two days after the date of the contact are known
as the Spot transactions.

• The rate of exchange effective for the spot transaction

is known as the spot rate and the market for such
transactions is known as the spot market.
• Currency forward market involves transactions in which
the exchange of currencies takes places at a specified
future date, subsequent to the spot date known as a
forward transaction.
• The forward transaction can be for delivery at a pre-
agreed future point in time at a specified price.
• Futures, Options and Swaps are called derivatives because
they derive their value from the underlying exchange rates.

• Futures market is a standardised version of a forward

contract that is publicly traded on a futures exchange. Like a
forward contract it includes price and the time in the future
to buy or sell an asset.

• Options: An option is a contract or financial instrument that

gives holder the right, not the obligation, to sell or buy a
given quantity of an asset as a specified price at a specified
future date. An option to buy the underlying asset is known
as a call option and an option to sell the underlying asset is
known as a put option
• Swaps, as the term suggests, are simply the instruments that
permit exchange of two streams of cashflows in two different
currencies.

• The term swap in currency market terms can be understood as

simultaneous sale of spot currency for the forward purchase of
the same currency or the purchase of spot for the forward sale of
the same currency.

• The spot is swapped against forward.

 Nostro account
• Nostro account is an account maintained by bank in India with a
bank abroad. For example, Indian bank may maintain an account
with Grindlays Bank, London. Obviously, the account would be in
Pound - Sterling. Similarly, it may have a Dollar account with bank
of America, New York.

• While corresponding with the foreign bank, Indian bank would refer
its accounts with the former as Nostro account, meaning our
account with you’.

• So, for Indian bank Nostro account means the bank account, it
maintain abroad in foreign currency. All foreign exchange
transactions are routed through nostro accounts.
• For example, if the bank issues a demand draft on London
payable in Pound - Sterling, it would draw on Grindlays bank
London. When the drafts is presented in London, the
Grindlays bank will debit the Indian bank’s account with it.

• Likewise, when a bill drawn on London is given to Indian

bank for purchase or collection, it would send if for
collection to Grindlays bank. Grindlays bank would collect
and credit the account of the Indian bank with the proceeds.
 Vostro account
• a foreign bank may open rupee account with an Indian
bank.

• While corresponding with the Indian bank would refer the

account as vostro account meaning your account with us
for example, a bank in middle east may open an account
with an Indian bank and draw drafts on the account.

• On presentation of drafts, the Indian bank would pay to the

debit of the foreign bank’s account with it.
• For exchange control purpose, such principal accounts are
known as non - resident bank accounts.
• It should be noted the credit to a non - resident bank account
amounts to remittance of foreign currency from India to the
country of the bank maintaining the vostro account.

• Similarly, debit to the account amounts to inflow of foreign

exchange from the country concerned into India.

• For instance, when an import is made from Sri Lanka, the

proceeds may be credited to the vostro account, the amount
should have been remitted abroad.

• Besides, the balance in the account can be utilised to pay for

any exports from India to that country. Thus, debiting or
crediting of vostro account is subject to the rules and
regulations governing remittance of foreign exchange into and
from India.