Introduction to

Exchange Rates
Chapter-2
Exchange Rates

 Most of us know about the foreign exchange rates and

i.e. the price of on currency note represented in
another, e.g. Afs 45.70/$ means that one U.S Dollar is
for 45.70 Afghanis.
 But what some of us may not know is that there are
variety of exchange rates that exist at the same
moment between the same two currency.
 E-R is not only for the currency note but it exists for
bank drafts and cheques, and for the cheques issued by
corporations.
2011 October 03
Currencies Name Cash Selling Cash Buying Spread

USD 48.5000 48.3000 0.2000

EURO 64.9400 64.3400 0.6000

Pound 75.3600 74.5600 0.2000

SWISS 52.9200 52.4200 0.5000

Indian Rs. 1.0720 1.0620 0.0100

Pakistan Rs. 0.5471 0.5391 0.0080

Toman 0.0383 0.0377 0.0004

RIYAL 12.9500 12.8500 0.1000

DIRHAM 13.2000 13.1000 0.1000

The Foreign Bank-Note
Market
 Most of you would have primarily engaged in the ForEx
while traveling abroad, but the rate of ForEx posted for
travelers in the banks are the most expensive and
unfavorable.
 It is because of the spread which mean the difference
between buying and selling price.
 The reason is that traveler generally only trade small
amount, which nevertheless require as much paper
work as bigger commercial trade.
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 Other reasons are:

 To facilitate travelers the banks and exchangers must hold
many different currencies, which doesn’t earn interest.
 Opportunity cost and inventory cost.
 Risk of ForEx.
 Traveler cheques are better off in this regards.
 Banks usually collects foreign Bank Notes in retail
market but sells its surplus amount in whole sale to
bank-note wholesalers.
The Spot Foreign Exchange
Market
 This is far larger than bank-note market, it is usually
involved with the exchange of currencies held in
different currency- denominated bank account.
 In each exchange the deposits are transferred from
sellers to buyers accounts, either taken place through
electronic messages or of bank drafts.
 Delivery on such transaction are immediate, usually in 1
or 2 days.
 Different from Forward market.
Organization of the Interbank
Spot Market
 The largest financial market on earth. The daily
turnover is almost one trillion dollars.
 It is an informal arrangement of the larger commercial
banks and a number of ForEx brokers.
 They are linked together by telephone, telex, and
satellite communications network called Society for
Worldwide International Financial Telecommunications
(SWIFT).
 Based in Brussels, Belgium.
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 In most of the markets (internationally) there are two

levels on which the ForEx market operates, a direct
interbank level and indirect level via brokers.
 In direct level banks trade directly with each other,
quotes buying and selling price to each other and is
known as Open Bid Double Auction.
 In case of brokers, the banks put an order on broker to
buy or sell different denomination of currency, known as
Limit book, single auction.
 Orders Orders
Central bank
placed placed

Orders Orders
Open-bid
placed placed
Double auction

Commercial bank Commercial bank

Companies Orders placed Companies
Exchange
Orders placed
Broker
Inside spread shown
Inside spread shown
Delivery Dates and Procedure for Spot
Exchange

 Bank-Notes exchange over the counter are

instantaneous in real time.
 When exchange is made in interbank spot market funds
are not usually received until 2 business days.
 Will the exchange rate be the same on date of
transaction?
 Distinction between value date and the initiation date
of transaction.
 Illustration.
 Suppose a Financial Executive of an American corporation, Amcorp, calls
his bank, Ambank National, a large currency-dealing bank in New York City,
to buy £1 million. Suppose the call is placed on Thursday, and that the
British pounds are to be used to settle Amcorp’s debt to Britcorp.
 Ambank will quote an exchange rate at which it will sell Amcorp the £1
million. If Amcorp approves of this rate, then the ForEx department of
Ambank will request details for making the payment in Britain.
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 These details will include the bank at which Britcorp is

to be paid and the account number.
 The details will typically be conveyed to the designated
bank in Britain, Britbank, by sending a message on the
day of ordering the pounds, Thursday, via SWIFT.
 The spot rate that is agreed upon by Ambank National
on Thursday will be binding and will not be changed
even if market conditions subsequently change.
 Continue:
 A confirmation of the order for £1 million at the agreed exchange rate~
e.g. $1.6000/ £~ will be sent out to Amcorp on Thursday, August 26.
 Because of the intervening weekend, the value date, which is 2 business
days later, is Monday, and on this day Ambank will debit Amcorp’s account
at the bank by $1.6 million.
 On the same value date Britbank will credit Britcorp’s account £1 million.
 Transaction is now only complete for payer and payee
 Continue:
 Settlement between the banks.
 The bank that has purchased foreign currency will have to pay the bank
that has sold the foreign currency.
 Takes place via clearing house. (joint institution at which banks keep
funds which can be moved from one bank’s account to another’s to settle
interbank transactions)
 CHIPS acronym for the Clearing House Interbank payment system, located
in New York.
Bank Settlement via CHIPS

 Computerized mechanism through which banks hold US

dollars to pay each other when buying or selling ForEx.
 System is owed by the large New York clearing banks;
has over 150 members, including subsidiaries of many
foreign banks.
 For working mechanisms Lets extend the same example
of Ambank National.
Continue:

 When Ambank agrees with Amcorp to sell £1 million,

Ambank enters the interbank market to replenish its
pound account at Britbank.
 Suppose after few telephone calls Ambank finds the
chepest rate on pounds to be at UKbank.
 Say UKbank has just paid out US dollars for a client and
wants to replenish its dollar holdings.
 On agreeing to buy £1 million form UKbank, Ambank
gives instructions to deliver the £1 million to its account
at Britbank.
Continue:

 Ambank payment to Britbank will be effected when

Ambank enters into its CHIPS computer terminal its own
code, that of UKbank, and the number of dollars to be
paid.
 Similarly, UKbank enters its code, Ambank’s code, and
the number of dollars to be received.
Retail versus Interbank Spot
Rates
 Exchange rates between banks are determined in the
interbank market.
 While exchange rates faced by banks’ clients are based
on these interbank rates.
 Banks charge their customer slightly more than the
going interbank selling rate, or ask rate.
 While pay slightly less than the interbank buying rate,
or bid rate.
 Customer Drafts and Wire
Transfers Banks communicates
the schedule of payment 5. Pays the creditor
2. Bank sells draft
out of the account
payable to foreign
of issuer bank
creditor, drawn against
account the bank
maintain in foreign
country
Foreign
Local Bank
Bank

Mechanism of Draft

Customer
Foreign
1. Customer
request Creditor
ForEx, for 3. Customer mails
4. Creditor receive
paying draft to Creditor
draft and demands
Foreign
payment from the
Creditor
bank mentioned on
Continue: (Wire Transfer)

 A speedier mode of settlement than a draft.

 Instructions are sent via SWIFT.
 Customers pays the bank a charge slightly more than
draft.
 Banks maintain accounts at correspondents in all major
countries to help their customers to make payments in
these countries and to earn the fees charged for their
services.
Direct versus indirect exchange and
cross exchange rates.

Mostly the When one

currencies are currency is
quoted against converted or
dollars, which is
known as
$ quoted against
another via dollar,
Direct rate. S( that is known as
£/

€)
$ indirect rate
$/
S( )
S(
$/

$)
£
€/
S( )
S(€/£)

€ £
S(£/ €)
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The Concepts of: Cross rates are
exchange rates directly
 Zero Foreign Exchange between currencies
Transaction Costs when neither of the two
currencies is the US $
 Nonzero Foreign
Exchange Transaction
Costs
S(€/£)

€ £
S(£/ €)