Types of transactions in foreign exchange market
The price quoted for currencies in the market is of two types.
1. Spot market and
2. Forward market.
Spot market transactions are valid for 48 hours and the price refers to current transactions.
Forward market refers to the price quoted for future date which may be ranging from 1 month to 6 months. The maximum period for a forward contract is six months. The forward market price may be at par, at discount, or at a premium. At par price refers to spot market price. That is, there is no change between the exchange rate of spot market with forward market. In the case of forward market price at discount, the forward market exchange rate will be lesser than spot market. In the case of premium, the forward market rate will be in excess of spot market rate.
Example: Spot market price of one U.S. dollar = Rs. 67.67.
Direct quotation and indirect quotation: In foreign exchange quotations, the price of a currency given in terms of another currency can be classified into two types. For example, we can quote in India the price of U.S. Dollar in terms of Indian rupee or the price of Indian rupee in terms of U.S. Dollar.
A direct quote is the price of one unit of foreign currency in terms of INR.
Example: One U.S. Dollar = Rs.50.
Indirect quote is the price of one unit of domestic currency in terms of foreign currency. So, Re. 1= 2 cents or 0.02 dollar (one dollar is equal to 100 cents).
In other words, direct and indirect quote of prices are reciprocals and in terms of mathematical expression, the direct quote is inversely proportional to indirect quote.
Cross Exchange rate: When the exchange rate of two different currencies belonging to two different countries are determined through the exchange rate of domestic currency, it is called cross exchange rate.
Example: One US dollar = Rs. 67.67, One Pound Sterling = Rs. 99.02.
Now, we can arrive at the exchange rate of 1 Pound Sterling in terms of US dollar, as 1 Pound sterling = 1.46 US dollars.
The purpose of cross exchange rate is to take advantage of the difference in the exchange rate between two markets.
Suppose, in London Market 1 Pound Sterling = 1.71 US dollars, Indian banks will take advantage of the lower rate in India (1.46 dollars) and will resort to currency swap. The difference in the exchange rate between two markets enables the brokers to earn profits which is known as Arbitrage. In our example, the pound sterling rate between Indian market and London market differs by 0.25 dollar, which is called the Arbitrage.
In India, from August 1993, banks are quoting foreign exchange rates on direct basis, whereas it was on indirect basis prior to that.
Classification of foreign exchange transactions
The following are some are the classification of transactions in foreign exchange
1. Spot transactions: Price quoted for purchase or sale of transactions is done within 48 hours or within two business days.
2. Forward transactions: Delivery at a specified date in future.
3. Swap transactions: Purchase in the spot market and sale in the forward market or sale in the spot market and purchase in the forward market.
Purpose of Swap transactions: In the foreign exchange market due to various reasons, the value of currencies fluctuates. It may be due to political reasons, war and also due to fluctuations in production agreed to by international cartels like OPEC (Organization of Petroleum Exporting countries). In such a situation, a country like India which is intending to import goods in the next 6 months, will have to make arrangements for foreign exchange.
For example, as on date, the exchange rate may be 1 U.S. Dollar = Rs. 67/-. But after 6 months, due to the reasons stated above, the exchange rate may go upto 1 U.S. Dollar = Rs. 77/-. This will bring a loss of Rs. 10 per dollar to India, when India is importing goods.
To minimize this loss, India can resort to purchase of currencies in the forward market. If the forward market is not favorable, then India may go in for swap transactions. That is, it can enter into forward purchase and spot sale, whereby India can buy at Rs. 67 per dollar in the forward market and if the rate goes below this, say Rs. 62 per dollar, India can now reverse the transaction. That is, it will buy in the spot market at Rs. 62 per dollar and sell the same for Rs. 67 in the forward market after 6 months. Thus, the loss of Rs. 5 is made up. This is known as swap transactions and since it is pertaining to currency, it is called Currency Swap
Interest swap: There are two types of interest rates, namely, fixed rate and floating rate. In the case of fixed rate of interest, the interest rate remains constant throughout the transactions. In the case of floating rate of interest, the interest rate will fluctuate according to the market conditions. Sometimes, the interest rate will decline and at this point, the borrower can switch over from a higher interest rate lender to a lower interest rate lender. We can explain this with an example.
Suppose, a person borrows a housing loan from a house finance company at 17% interest. Commercial banks have introduced floating rate of interest for housing finance and they offer housing loan at 10% interest rate. So, the borrower will settle his loan with the housing finance company through the commercial bank and now will be a borrower of the commercial.bank at 10% interest. This is interest swap.
4. Option Transactions: The option trading in forward market, is mainly for avoiding risks. It is a part of exchange risk management. When we minimize the loss of current transaction by a forward transaction or vice versa, it is called hedging. In the option transaction, a person can exercise the option to buy or sell. One is called call option and the other is called put option. It provides a choice for the person to fulfill the contract or withdraw &om the contract. But when a person withdraws from the contract, he may have to pay some margin money as decided by the market condition. Thus, the option trading enables a person to either take a risk or avoid the risk. In this way, the market enables a smooth fluctuation in the foreign exchange rate.
A foreign exchange quotation has also got a two-way price. One for buying and another for selling. This is called bid, offer and spread.
- Bid: A bid is a price offered by a dealer to buy another currency.
- Offer: It is a rate at which the dealer is willing to sell another currency.
- Spread: It is the difference between the bid and offer. This is the profit which the dealers book, due to the difference between bid price and offer price.