Before we move forward with this module, we should know about some basic terms which are related to currencies.
What is an Exchange Rate?
An exchange rate between two currencies specifies how much one currency is worth in terms of the other. For example, an exchange rate of ₹67 to USD means that ₹67 is worth the same as 1 USD.
An exchange rate quotation is given by stating the number of units of "term currency" or "Quote currency" that can be bought in terms of 1-unit currency or Base Currency. Thus, in the quotation on the NSE currency trading terminal which says that the USD/INR exchange rate is 67.40 INR per USD, the term currency is INR and the base currency is USD.
Bid price: is the price which potential buyers are willing to pay
Ask price: also known as the 'offer price', is the price at which sellers are willing to sell
Bid Ask Spread: is essentially the difference in price between the highest price that a buyer is willing to pay and the lowest price for which a seller is willing to sell an asset
Typical exchange rate quote is like USDINR = 67.4150/75
Bid-Ask Spread is (67.4150-67.4175) = 0.0025
Source: NSE India
What is the Spot Exchange Rate?
A spot exchange rate is the current price level quoted in the market for the immediate delivery of one currency to another. The standard settlement convention for Foreign Exchange Spot trades is T+2 days, i.e., 2 business days from the date of trade execution. An exception is the USD/CAD (US–Canadian Dollars) currency pair which settles T+1.
What is Forward Exchange Rate?
The forward exchange rate refers to an exchange rate that is traded and quoted today but the payment and delivery of that contract are on a specific future date.
What is Forward Premium?
A currency is said to be trading at a premium in the forward market if its value in the forward market is higher than in the spot market. For example, the spot exchange rate for USD/INR is 44 and if a 6-month forward contract of USD/INR is trading at 44.5, then it is said that USD is trading at a premium of 50 bps against INR in the forward market.
What is Forward Discount?
A currency is said to be trading at discount in the forward market if its value in the forward market is lower than in the spot market. For example, the spot exchange rate for USDINR is 44 and if a 6-month forward contract of USDINR is trading at 43.5, then it is said that USD is trading at a discount of 50 bps against INR in the forward market.
What is the Spot Forward Relation?
In international markets for fully convertible currencies, the forward premiums/discounts are purely a function of the difference between interest rates of the 2 countries that have fully convertible securities. Under covered interest rate parity in a two-currency pair, the currency of the country with a higher interest rate than that of the other will trade at a discount to the other currency.
F = Forward Rate
e = Spot Rate
if = Interest Rate in the term currency
i = Interest rate in the base currency
For example, On June 30, the spot USD/INR rate was 67.42. The US interest rate is 0.50% and Indian interest rate is 6.50%,
E=67.42; Idc = 0.065; Ifc = 0.005.
F = 67.42(1+0.065) / (1+0.005)
Therefore, the forward rate will be 71.4450 for 1 USD.
In the case of India, this stated spot forward relation between USD/INR does not work completely because India follows a managed floating exchange rate regime. As stated, RBI from time to time trades in the market to maintain a stipulated level of the exchange rate to support both the exporters and importers.
What are Swaps?
A foreign exchange swap is a simultaneous sale and purchase, or vice versa, of an identical amount of one currency for another with two different values. The two commonly used swaps are:
- Interest rate swaps: This involves swapping only the interest rate between 2 parties of similar currency.
- Currency swaps: This involves swapping both interest and principal between 2 parties, with the cash flows of 2 parties being different.