EXCHANGE RATE MECHANISM

An exchange rate is a simple arithmetical expression which gives value of one currency in
terms of another. The exchange rate is therefore a bilateral rate expressing relative price of
country’s money. The exchange rates have developed over a period of time moving through
different stages – Controlled or Fixed rates, Managed Rates and Independently floating rates.

Any exchange rate can be expressed / quoted either in direct or indirect method. In both the
methods, you would get the same value, as the difference lies the way you look at it.

Direct Method: In Direct quote, also called Home Currency quotation or Price Quotation system,
number of units of local currency (Home currency) per unit of foreign currency is given. This
means, while the home currency will be variable, the foreign currency unit will be constant. Eg:
USD/INR = 66 or 1 USD = Rs 66. This means the rupee cost of one USD is obtained directly.
However, due its low value, Indonesian Rupiah, Japanese Yen & Kenyan Schilling are quoted in
100 units instead of one unit.

Indirect Method: In Indirect quote, also called Foreign Currency quotation or Volume Quotation
system, number of units of foreign currency per unit of local (home) currency is given. Eg:
INR/USD = 0.01515 or 1 INR = USD 0.01515 or 100 INR = USD 1.515. In international markets,
British Pounds (GBP) and Australian Dollar (AUD) are the major currencies quoted in the indirect
method. While the rest of currencies are quoted in direct method against US Dollar.

In fact, Direct quotes and Indirect quotes are reciprocals of each other and can be derived as
shown below:
Direct quote = 1/Indirect quote or Indirect quote = 1/Direct quote.

Exchange rates are expressed as two way quotes – Purchase & Sale transactions. If quote for
USD/INR as on date shows 68.1000/68.7500, means the dealer is bidding to buy USD at 68.1000
rupees and offering to sell (also called ‘Ask” rate) USD at 68.7500 rupees.

Exchange Rate Definition: Exchange rate is defined as the rate at which one currency is
exchanged for another currency. To elaborate further, the number of units of one currency
which exchange for a given number of units of another currency is the rate of exchange.

Exchange Rates – History: It can be noted that during 1900-1930 era, convertibility existed &
currencies operated under a fixed exchange system based on gold and silver standards where
the respective governments were willing to redeem currencies against specific amount of gold &
silver. During that era, British Pound & USD were the dominant currencies. Since telegraph was
the only means of communication, the international foreign exchange markets were isolated
from each other. The great depression of 1930 put an end to this convertibility. Major countries,
one by one, started abandoning the gold & silver standards during 1930-1943 period. With
advent of World War II (1939-44) the foreign exchange market virtually ceased to exist.
The foundation for the post Second World War international monetary system was laid in the
year 1944 in a conference held at Bretton Woods, New Hampshire, USA. Under the new system
a modified return to the gold standard and convertibility paved the way for the expansion of
international trade and the world economies started recovering.
While the Bretton Woods system was a return to the metallic standard, it also consecrated the
dominance of USD by pegging par values of convertible currencies against it. Initially the par
values were established on a bilateral basis. There were hardly any movements in the exchange
rates under such a regime.
The improvement in telecommunication facilities and the restoration of convertibility brought a
new impetus to the foreign exchange (forex) markets. As the economies of Western Europe
started to grow, international trade developed and USD turned to be an undisputed strong &
lead currency. A strong US Dollar led to increased American investment abroad and this resulted
into a deficit in the US balance of payment. On the other hand, the US government was still
committed to convertibility and to exchange gold for US Dollars. The continued strength of USD
brought massive purchase of gold.
The increased US involvement in Vietnam War aggravated the external situation of USD. The
drain in gold continued so much so that by the beginning of 1968, the official international gold
payments were suspended, signaling an end to the era of fixed gold price. By the beginning of
1971, the downward pressure on US Dollar became massive, fuelled by increasing balance of
payment deficits. The gold window was closed on 15th August 1971, thereby putting an end to
the convertibility of USD to gold and breaking down of Bretton Woods system. In its place
Smithsonian Agreement entered with par values called as controlled rates and bands to
distinguish from Bretton Woods. From this moment onwards the foreign exchange markets
operated under a non-system, with emergence of floating exchange rate.

Factors affecting Exchange Rates: In the case of fixed exchange rates, rate will not move beyond
respective lower

and upper intervention points except when there is devaluation or revaluation. But in a floating
exchange rate system, the exchange rate of currencies used to fluctuate because of demand &
supply factors or is a market determined rate. Still, even in the floating rate system, Central
Banks of many countries (in India by RBI) used to intervene in the market whenever there is
volatility in the rates. This is in order to curb the volatility/ speculation and calm the volatile
market. This system can be called as ‘Dirty floating’ or ‘Managed Floating’, which many
countries (including India) are now following in the forex market.

Due to vastness of the market, operating in different time zones, most of the forex deals are
done on spot basis, meaning the delivery of the funds takes place on the second working day
following the date of deal/contract. The rate at which such deals are done is known as ‘Spot’
rates. Spot rates are the base rates for other foreign exchange rates. The date on which the
delivery of funds (means exchange of currencies) actually takes place is called the ‘Value date’. It
can be seen that the delivery of forex deals can be settled in one or more of the following ways:

1. Ready/Cash: In this case, Settlement of funds takes place on the same day (date of deal).
If the date of Ready/Cash deal is 15th February 2016, settlement date also will be 15th
February 2016.
2. Tom: In this case, settlement takes place on the next working day of the date of deal. If
the date of the Tom deal is 15th February 2016 (Monday), settlement date would be 16th
February 2016 (Tuesday), provided it is a working day for the markets dealing as well as
 where the currency is to be settled. If Tuesday is a holiday in any of the two countries,
then the settlement date will be the next working day in both the countries.
3. Spot: In this deal, settlement of funds takes place on the second working day
after/following the date of contract/deal. If the date of spot deal is 15 th February 2016
(Monday), then the settlement date will be 17th February 2016 (Wednesday), provided
all the markets are working on 15th, 16th & 17th February 2016. If not it will be the next
working day in both the countries.
4. Forward; In this case the delivery of funds takes place any day after Spot date. If the
date of forward deal is 15th February 2016, for value settlement dated 20th February
2016 or 31st October 2016, it is a forward deal.

In a free market, the exchange rates would be based on the demand and supply factors. A
currency in excess supply would tend to become cheaper and a scarce one costlier, till a balance
between demand and supply is struck. Besides, given the connection between exchange rates
and funds cost in a totally free market, the interest rate differentials for the two countries would
be reflected in the forward exchange rates. The relationship between spot rate and forward rate
of any two currencies depend first on the relative rates of interest obtainable on similar types of
securities in the two countries and secondly on the relationship between the demand for and
the supply of forward currency in the markets.

Thus Forward rate = Spot rate plus Or minus Forward margin. The forward margin can either be
premium or discount. If forward margin is at premium, then it shall be added to the spot rate to
derive the forward rate and if it is discount, it shall be deducted from spot rate to get the
forward rate.

If a currency is at premium, means that the forward value of that currency is higher than the
spot value. This means a currency is said to be at a premium if it commands more of the other
currency in the forward than in the spot.

If a currency is at a discount, means that the forward value of that currency is lower than the
spot value. This means a currency is said to be at discount if it commands less of the other
currency in the forward than in the spot.

It shall be noted that a currency with a higher rate of interest is said to be at a discount in the
forward, relative to the currency with a lower rate of interest and a currency having a lower rate
of interest is said to be at a premium in the forward, relative to the currency with a higher rate
of interest. This means, if the interest rate of a domestic currency is higher than that of a foreign
currency, then the foreign currency will be trading at a premium in the forward rate. This implies
the fact that the higher the interest rates in a domestic currency relative to the foreign currency,
the higher the forward premium for the foreign currency. Obviously it will be discount for the
foreign currency if the interest rate of a domestic currency is lower than that of a foreign
currency.

Thus the forward price/rate of a currency against another can be worked out with following
factors:

i) Spot price of the currencies involved.

ii) Interest rate differentials for the currencies.
 iii) Settlement time, i.e., the future period for which the price is worked out.

As stated above the quotes in the forex markets depend on the delivery type of the foreign
currencies, i.e., exchange of streams of the two currencies being exchanged. The spot rates,
being the base quotes in the forex markets are more dynamic and are affected by varied
reasons, a few of which are fundamental and others technical. These factors which

influence movement of exchange rates can be classified as Short-term factors & Long-term
factors and are summarized as under:

Short-term factors: (i) Commercial and (ii) Financial.

A country’s current account balance is a better indication of exchange rate trends. A surplus,
i.e., foreign exchange net inflows from export earnings pushes that country’s currency higher. A
nation’s international competitiveness and with it the trend of its current account depends on
different factors.

a) Inflation will diminish exports after a certain future period and increase imports.
b) Higher economic growth.
c) Foreign currency inflows & outflows from trade & services (banking, insurance, shipping,
tourism etc,,).
d) Loan and interest receipts & payments by private and public sector.
e) Salaries and profits of foreign companies and their remittances.
f) Capital movements: Sometimes they dominate exchange rate developments for weeks and
months. Period of investment also influences it. Capital movements can change direction
abruptly and on a large scale basis.
g) Technical factors: For short periods, technical factors can also have an influence. Regulations
by central banks about the size of open position may, for instance, make it necessary to reduce
or cover short positions at any given moment, which creates a technical but not genuine
demand for that currency.

Long-term factors: (i) Currency & economic conditions and (ii) Political & industrial conditions.

a) Economic factors are of decisive importance.

b) Non-economic factors: Political and/ psychological factors can also have a bearing on
exchange rate behaviour, mainly by inducing flows.
c) Market participants not only act on the basis of known facts and figures, but also base
themselves on expectations. This factor also adds to the volatility of the forex markets under a
floating exchange rate regime.
d) Speculative activities by private sector (wherever permissible/feasible): Operations of central
bank of the country to control volatile variations/fluctuations in exchange rates result in keeping
the value of currency under control.
e) Industrial conditions: The current position and future outlook in the industrial field are also
important influences in the exchange market. Existence of industrial peace, stable levels of
wages & prices and higher levels of efficiency in production have a strengthening effect on the
exchange value of the currency in the long term. Opposite will have an adverse impact on the
exchange value of the currency. Effect of economic and political factors on exchange rates is
further accentuated by speculation, which creates considerable uncertainty and disturbances in
the exchange markets.

Long-term Periods: Purchasing Power Parity theory under a generalized system of clean floating
exchange rates responds to inflation differentials. This is a good theory for long term exchange
rate movements. Purchasing Power Parity (PPP) is an economic theory that estimates the
amount of adjustment needed on the exchange rate between countries in order for the
exchange to be equivalent to each currency’s purchasing power.

RBI/FEDAI Guidelines: Foreign exchange business in India is administered by RBI and they have
in turn delegated powers to banks to transact actual exchange business. Banks that transact
exchange business under license from RBI are designated as Authorized Dealers (Authorized
Persons). RBI also prescribes exchange control regulations which are reviewed from time to
time.
To ensure that those handling exchange business observe uniform norms and procedures, RBI
has handed powers to Foreign Exchange Dealers’ Association of India (FEDAI) to frame
guidelines for transacting exchange business. FEDAI has issued guidelines on the quotation of
merchant rates- spot and forward. Delivery of forward contract is as per the maturity date of the
contract. For option delivery contract, the period of delivery is indicated from the first date and
last date option. In India the option period is restricted to a maximum of one calendar month.
For example: January 15 to February 14. Forward contracts can be extended or cancelled any
time during the life of the contract. In the absence of any instructions from the customer,
contracts which have matured will automatically be cancelled by the AD on the 3rd working day
from the day of maturity. All cancellations shall be at bank’s opposite TT rates, TT selling rate for
purchase contracts and TT buying rates for sale contracts. All rates are to be quoted up to 4
decimal points and rounded off in multiples of 0.0025 paise.

Foreign Exchange Dealing: Managing foreign currency assets and liabilities is the prime activity
for a bank in the matter of forex dealing. Forex dealers manage cash flows (in various
currencies) and provide quotes to clients to undertake forex transactions. Dealers also
undertake trading with various counter parties, hedge their risks and also provide liquidity to
the market.

Job of a forex dealer is a highly professional one with the ability to take quick and apt decisions
by tracking the market across the globe. In this respect, various directives and guidelines have
been issued by RBI and FEDAI, based on which each bank’s Board has framed a policy for dealing
room operations. Dealers are bound to follow these guidelines meticulously.

Forex dealing room in a bank can be divided into three:

Front office: Here the dealer provides quotes and closes deals.

Mid office: Undertakes risk management and regulatory compliance.

Back office: Settlement and accounting responsibility.

Exchange Arithmetic- Theoretical overview: All foreign exchange calculations have to be
worked out with extreme care and accuracy and also the use of decimal point has to be
correctly placed. Constant check is also strongly advised to minimize the risk of mistake, as the
markets work on very thin margins. An error in one quote may erode earnings from several
trades/transactions.

Chain Rule: It is used in attaining a comparison or ratio between two quantities linked together
through another or other quantities and consists of a series of equations, commencing with a
statement of the problem in the form of a query and continuing the equation in the form of a
chain so that each equation must start in the terms of the same quantity as that which
concluded the previous equation. For example, if in the market there is a quote for USD/INR =
61.5000 and for USD/JPY = 100.0000, then we can derive the rate for JPY/INR using the chain
rule method. To elaborate further, we can see that 1 USD = 61.5000 INR & also 1 USD = 100 JPY,
which means 100 JPY = 61.5000 INR. Hence 1 JPY = 61.5000 / 100 = 0.06150 INR. So, 100 JPY =
61.50 INR. (JPY is quoted per 100 units due to their low values). So the quote will be 100JPY/INR
= 61.50. This is the principle lying in 'Cross Rate Mechanism'.

Cross Rate Mechanism: This method is used for calculating rates of currency pairs which are not
actively traded or quoted in the market. This means cross rate mechanism is used to derive rate
of a currency pair, when there is no quote for it in the home country. For example, in the market
if quote for USD/INR = 61.5000 and for Euro/USD = 1.4300, then Euro/INR is 61.50 x 1.43 =
87.9400 INR. To elaborate further, we can see that 1 USD = 61.5000 INR, then 1.43 USD (which is
equal to the value of 1 Euro) will be 61.5000 x 1.43 = 87.9400 INR, which is equal to 1 Euro.
Hence the quote for Euro/INR = 87.9400.

Value date: This is the term used to define the date on which a payment of funds or an entry to
an account becomes actually effective (Realization date).

Arbitrage in Exchange & Cross Rates: Arbitrages consist in the simultaneous buying and selling of
a commodity in two or more markets to take advantage of temporary discrepancies in prices. As
applied to dealings in foreign exchange, arbitrage consists of purchase of one currency for
another in one centre accompanied by an almost immediate resale against the same currency in
another center, or in operations conducted through three or more centers and involving several
currencies.

Merchant Rates: The exchange rates (Buying and Selling) quoted by AD banks to their customers
are known as merchant rates. Following are different types of merchant rates:

a)T.T (Telegraphic Transfer) Buying: Inward T T favouring beneficiaries in India. While quoting
the rate, exchange margin is to be deducted from interbank buying rate and rounded off as per
FEDAI guidelines.
b)T.T Selling: Outward T.T favouring beneficiaries abroad. While quoting rate, exchange margin
is to be added to inter-bank selling rate and rounded off as per FEDAI guidelines.
c)Outward Mail Transfer (M T) and Demand Drafts (DDs): Instructions for payment to
beneficiaries abroad are sent to payee bank by post in the case of MT. Similarly, a Demand Draft
is a written order issued by a bank to another bank or its own branch at another center for
payment to the beneficiaries. As both MTs & DDs involve handling of documents, an extra
margin is added to T T selling rate for arriving exchange rates for MTs/DDs.
d)Bill Buying: Purchase/discounting of bills and other instruments this rate shall be applied. In
the case of TT Buying, credit is already received in our Nostro account. But in the case of bills,
bank has to claim cover after payment from the drawee bank who will be remitting cover for
credit to a different center at a later stage. Since additional works are involved, the exchange
rate quoted for Bill Buying will be lesser compared to TT Buying.
e)Bill Selling: For transactions involving transfer of proceeds of import bills, even if proceeds are
remitted to overseas country by way of DD, MT, TT or PO, Bill Selling rate shall be applied. Since
additional paper works are involved, the rate will be a little bit higher compared to TT Selling
rate.

f)TC/Foreign currency/DD/Cheque purchasing: AD banks can decide the exchange rate for such
transactions.

FEDAI guidelines: All rates are to be quoted up to 4 decimal points, rounded off in multiples of
0.0025 paise.

Conclusion: It can be seen that foreign exchange markets play a vital role in integrating the
global economy. In fact it is a 24 hour market (because of different time zones) and over the
counter market – made up of different types of
Players, with its own set of rules, practices and disciplines. Nevertheless the market operates on
a professional basis and this professionalism is held together by the integrity of the players.

The Indian Foreign exchange market is no exception to this international market requirement.
With the Liberalization, Privatization & Globalization (‘LPG’) initiated in India, Indian foreign
exchange markets have been reasonably liberated to play its role effectively. However much
more needs to be done to make our markets vibrant, deep and liquid.

Foreign exchange dealing rooms are the backbone of any foreign exchange market because of
the sheer size of operations handled by the dealing rooms in the foreign exchange markets.
They have to be effectively organized to perform their functions. More important is the
management and control of dealing rooms. Dealing in forex business is a specialized subject
with involvement of many terminologies and conventions. One will be able to arrive at the right
or actual price of a currency only if he understands these terminologies and conventions.

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[Compiled by Sri. Madhavan. A – Ref: Various publications of RBI and FEDAI]