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FOREIGN EXCHANGE | FUNDAMENTALS OF FOREIGN EXCHANGE | FREE JAIIB AFB NOTES | JAIIB EXAM 2022

FREE JAIIB AFB NOTES ON FOREIGN EXCHANGE FOR JAIIB EXAM 2022 | FUNDAMENTALS | INDIAN FOREX MARKET | RATES

Understand the concept of ‘Foreign Exchange & related terms’ of the JAIIB syllabus applicable for JAIIB AFB Exams 2022.

These are another set of notes on the accounting and Finance for bankers, second paper of JAIIB 2022. After going through this article, you will be able to better understand the concept of phone in exchange and the terms which are usually used when we deal in foreign exchange such as Indian forex market, direct and indirect quotes, cross rates, chain rule, value date, forward rate, premium, discount, forward points etc. which fall under the prescribed syllabus of JAIIB EXAM 2022.

WHAT IS THE MEANING OF FOREIGN EXCHANGE?

When one currency is traded for another currency is known as Foreign Exchange.

Example: When Canadian Dollars were swapped for Indian rupees, it would be referred to as foreign exchange.

The transactions related foreign exchange take place in the foreign exchange market which is known as the forex market.

WHAT ARE THE FUNDAMENTALS OF FOREIGN EXCHANGE?

Foreign exchange has three fundamental aspects in its general working. These aspects are explained in the below lines:

  • Every country has its own currency which is usually denoted as legal tender & is useful only in that country.
  • The currencies are exchanged for other currencies through banks by way of passing entries.
  • All the exchanges of currencies are done through credit instruments.
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WHAT DO YOU MEAN BY INDIAN FOREX MARKET?

The forex market is a decentralized marketplace at the global level to trade foreign currency. It is basically an Over-The-Counter (OTC) market and all the foreign exchange rates are dictated by the forex market.

In the Indian forex market, the exchange rate movements do not follow the international trend, especially in the short term. This inconsistency with the international market is because of this reaction to the free flow of capital (into or out of the country) prevalent in the country.

Before ‘LERMS – Liberalised Exchange Rate Management System’ came into existence, it was the RBI which used to fix the buying and selling rates of the currencies which would make the rates within the limit of ceiling and the floor.

But at present, it’s actually the local interbank market which determines the exchange rate as per the forces of demand and supply therein.

WHAT ARE DIRECT AND INDIRECT QUOTES?

Before we understand what are direct and indirect quotes, we must understand what is a quote in relation to the forex market.

Forex Quote: It is basically the price of one currency in terms of another currency. A quote is always quoted in pairs of currencies because it always involves buying one currency in exchange for another currency.

Example: If an Indian wants to buy US dollars, it will cost him ₹80 to get $1 & it will be quoted as USD/INR. 

DIRECT QUOTE: 

A quote is said to be direct when the price of one unit of foreign currency has been expressed in terms of the currency of the domestic country i.e home country.

Example: When we get to understand how much Indian rupees are required to purchase $1, it will be taken that a direct quote has been provided. 

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INDIRECT QUOTE:

A quote is said to be indirect when the price of one unit of domestic currency (Hone Currency) has been expressed in terms of the foreign currency 

Example: When we get to understand how many US Dollars are required to purchase ₹1, it will be taken that an indirect quote has been provided. 

FOREX QUOTES IN GENERAL

Because USD is the most dominant currency in the whole world, the exchange rates are usually expressed in terms of US dollars. But that does not mean that exchange rates cannot be quoted against other countries’ currencies. And when the exchange rates are quoted against other countries’ currencies, they are known as cross-currency rates.

MEANING OF LOW & HIGH QUOTE RATES – DIRECT OR INDIRECT QUOTES

When a low exchange rate has been quoted in a direct quote, it means that the domestic currency is getting appreciated in value i.e to say it worth more than the foreign currency while when the low exchange rate has been quoted in an indirect quote, it means that the domestic currency is getting depreciated in value i.e to say it worth less than the foreign currency.

SOME BASICS RELATED TO EXCHANGE RATES

What is Cross Rate?

If a Punjabi wants to remit Canadian Dollar from India, and if we are to say, hypothetically, bank does not have INR/CAD quotes, it would mean that that Punjabi person will have to first buy US Dollars against Indian currency i.e rupees & then Canadian dollars will be purchased by using that US Dollars.

Example: The rates in Ludhiana market are US 1$ = Rs.80.8450/545 while the rates in London Market are US 1$ = Canadian Dollar 1.27. It means that we will get 1 USD for Rs.80.8450 & for 1 USD we will get 1.27 CAD. With the help of this, we can form a chain rule as follows:

How many ₹ = 1 CAD?

If 1.27 CAD = 1 USD & 1 USD = Rs.80.8450,

therefore, 1 CAD = Rs. 80.8545/1.27 or 1 CAD = Rs. 63.66

This is one way to calculate the rates when the exchange rate of two currencies which are actually Wanted is not available due to one another reason.

WHAT IS CHAIN RULE?

As we have seen above the calculation of cross rate is actually based on common sense & when the steps used for this Calculation are articulated, as a rule, it is known as the chain rule.

WHAT IS VALUE DATE?

Value date refers to the date on which the currencies are actually exchanged. On the basis of this concept, we have the following types of exchange rates in the JAIIB AFB syllabus 2022:

Cash/ready: The rate applicable on the date of deal when the currencies are actually exchanged.

TOM: When the exchange of currencies happens on the next working day of the deal, it is called the TOM rate.

Forward Rate: When the currencies are exchanged after a period of spot date, the rate applicable is called the forward rate. These rates are usually expressed for indicate discount or premium charged for the forward period.

Premium: When a contract is entered into to exchange the currency at a future date & the rate of exchange which is applicable or decided for that future date is costlier, it is said to be at a premium. 

When the quotations are given as direct quotes, a premium is required to be added to both the selling and buying rates.

Discount: When a contract is entered into to exchange the currency at a future date and the rate of exchange which is applicable at that future date is cheaper, it is said to be at a discount.

When the quotations are given as direct quotes, discount is required to be subtracted or deducted from the buyer and selling rates.

Forward Exchange Rates: The exchange rate at which a banker is ready to exchange one currency for another currency at a future date under a forward contract, it is called as forward exchange rate.

Forward Rate: 

It refers to the rate of exchange which is used to settle on a date which is beyond the spot. It basically has the following two components:

  • Spot Rate
  • Forward point which reflects the interest rate differentials adjusted for settling at different dates.
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Forward Point

Example: 

The spot rate of INR/USD: 1 USD = Rs.80.8450

The exchange rate for 3 months forward: 3 months INR/USD: 1 USD = Rs.80.8550

The difference between two rates Rs. [80.8550 – Rs.80.8450] = 100 points are the forward points

The following factors determine the forward point:

  • Forward point is affected by the following factors:
  • The supply and the demand for the currency on the date of settlement.
  • Expectations running in the market
  • Interest rate differential between two countries (whose currencies are being exchanged)

Forward differential: It is also sometimes referred to as the swap rate. By adjusting spot rate with the forward differential, we can arrive at a given forward rate.

Calculation of interest differential using forward points:

We can calculate the interest rate differential using the forward point as per the following formula:

Interest rate differential = Forward points × No. of days-in year ×100 /

Spot rate × Forward period-in days

Forward differential formula = Spot rate – Forward rate

ARBITRAGE

The process by which a person can make profits by setting up the transactions of purchase and sale is known as arbitrage.

The activity of arbitrage can be in interest rates by way of using the benefit of fluctuations in the same currency rates at two different centers. In the same way, arbitrage can also happen in exchange rates.

Note: Due to today’s efficient communication system, it is very difficult to take the benefit of arbitrage.

We sincerely hope that this article has been very useful and understandable for the candidates appearing for the AFB paper for the JAIIB Exams 2022. You can also read other notes on other topics from the JAIIB AFB Syllabus of 2022 on our official website.

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