Foreign exchange market –

The foreign exchange market is a global online network where traders buy and sell currencies. It has
no physical location and operates 24 hours a day from 5 p.m. EST on Sunday until 4 p.m. EST on
Friday because currencies are in high demand. It sets the exchange rates for currencies with floating
rates.

Participant # 1. Commercial Banks or Market Makers:

Commercial banks are normally taking over the position to support the economy of the country by
carrying over the foreign currency from one period to another, for meeting the future need of the
country. They are also sometime making short sale (agree to sell or actually sell the foreign currency
without any real capacity to sell through or borrow the required currency from others) of foreign
currency to satisfy the need of firms to make payments.

Later on to bring the position in equilibrium, they quote the rates for buying and selling of foreign
currency accordingly. As they are buying the foreign currency from the customer, the rate they
quote for buying the foreign currency is technically named as Bid rate. When they sell the foreign
currency to customer, the rate they quote is technically known as Ask rate.

Participant # 2. Foreign Exchange Brokers:

FE brokers do not buy or sell the foreign currency on their own account, as done by market makers.
They are working as an intermediary between two parties, to satisfy their respective needs. As they
are working as a bridge between buyers and sellers of the foreign currency, they are only earning the
fees in the form of brokerage charges.

Participant # 3. Central Banks or Reserve Bank of India:

To protect the financial strength and stability of the country’s balance of payments, internal money
supply, interest rates and inflation, RBI intervenes in the foreign exchange markets to protect the
disequilibrium in the prices of foreign exchange conversion.

Participant # 4. Corporates and Entrepreneurs:

Corporate are the players in the FE market, to satisfy their need of payment in foreign currency
towards imports of goods, commodities and services. On the opposite way, they need to convert
foreign currency in home currency on account of export of goods, commodities, and services. The
need of conversion also happens on account of transactions in financial markets across the globe, for
loan disbursement, repayment of loans, receipt and payment of annual charges, etc.
Spot quotation –

A transaction between two parties to exchange one currency for another at a rate which is agreed
upon today but whose settlement will take place in two business days.

For ex – If the contract is entered on 7th May, then settlement will take place on 9th May.

But if Ninth May is a holiday in either of the location then the settlement will roll to next business
day.

The currencies are represented as two way quotation and the following are the rules for interbank
dealing.

Two way quote RULES–

USD/INR SPOT 74.50/75.60

1. Each currency is denominated by three letter swift code ie INR, USD, CAD, AUD etc
2. The two currencies are separated by a hyphen or oblique.
3. The currency on our left is called Base currency and currency on our right is called quoted
currency.
4. The quote is in EUROPEAN TERMS OR AMERICAN TERMS or DIRECT QOUTE or INDIRECT
QUOTE.
5. In europen quote it is number units of currency per US DOLLAR EG – USD/INR = 75 WHICH is
read as 75 rs per us dollar.
6. In American terms it is no. of units of USD per unit of foreign currency
Eg CHF/USD 0.8040
7. DIRECT QUOTE is number of units of the home country currency per unit of foreign currency.
In India, the direct quote will be USD/INR =75
8. INDIRECT QUOTE has number of unit of foreign currency per unit of home currency.
In india, indirect quote is INR/USD = 0.0133
9. TWO WAY QUOTE
10. SPOT QUOTATION AND TWO POINT ARBITRAGE
11. THREE POINT ARBITRAGE
12. PRACTICE QUESTION DONE IN CLASS
I Purchasing power parity theory –

This theory is proposed under two variations. One is absolute version and other is relative version.
Let us understand both with examples.

a. Absolute version –
It states that exchange rate between any two currencies is the ratio of their purchasing
powers.
Example – suppose cost of basket of goods in United states of America is $1 and cost of
same basket in India is Rs75. Then according to Absolute version, exchange rate between
USD/INR is 75.
b. Relative version –
But because price level in each country are subject to factors like inflation, interest rates and
other economic factors and so another version of PPP was proposed which is called relative
version. It states that the exchange rate between any two currencies is subject to inflation
prevailing in both currencies under question. The theory states that the currency with high
inflation depreciates in future and hence it helps to predict the exchange rate in future.

It is given by
Fn(B / A) 1+ πA
=
S (B / A) 1+ πB

Or (Fn (B /A))/(S(B/A)) = (1+πA) (N/360)/(1+πB) (N/360)

This means that the the exchange rate will not be the ratio of purchasing power always, the
countrys currency where inflation is high will depreciate.
1. Spot rate is given by S(B/A)
Where B is base currency
A is quoted currency
2. Also spot rate at time today will be denoted by So and at any time future will be denoted
by S1.
PA 0
3. The spot rate is ratio of purchasing power as per absolute version. Therefore S0=
PB 0
…….eq 1
Example – In quotation USD/INR SPOT = 75,
Represented in S(B/A) form, USD is B and INR is A which mathematically is 75/1. So PA0
is price level in currency A ie quoted currency and PB0 is price level in currency A ie base
currency.
PA 1
4. Silmilarly Spot rate in future time S1 = ………………………….eq2
PB 1
5. If there is inflation of 10% in any currency then price level will be say 75 + 10% of 75 =
75(1+10%) which can be represented as denotations like PA1= PA0(1+πA) for currency A
and PB1 = PB0(1+ πB) for currency B
PA1/PAO = (1+πA)
And PB1/PB0 = (1+πB)……………………………eq 3
6. From equation 1,2 and 3
s 1 PA 1/ PB1
=
s 0 PA 0/ PB0
PA 1 PB 0
= ×
PB 1 PB1
PA 1 PB 0
= ×
PA 0 PB1
FROM EQUATION 3,
S1/S0 = 1+πA/1+πB
Or
(Fn (B /A))/(S(B/A)) = (1+πA)/(1+πB)
 DEPARTMENT OF MANAGEMENT
DATE 21 May 2021

The following faculties and staff have reported today

1. Mr Saurabh Tomar
2. Mr Sunil Kushwaha
3. Mr Gaurav Dewangan
4. Dr. Sanjay Guha
5. Dr. Urvashi Shrivastava

Head