The exchange rates quoted by banks to their customer are based on the rates prevalent in the interbank market. The big banks in the market are known as market makers, as they are willing to buy or sell foreign currencies at the rates quoted by them up to any extent. Depending buy or sell foreign currencies at the rates quoted by them up to any extent. Depending upon its resources, a bank may be a market maker in one or few major currencies. When a banker approaches the market maker, it would not reveal its intention to buy or sell the currency. This is done in order to get a fair price from the market maker.
Two Way Quotations
Typically, the quotation in the interbank market is a two – way quotation. It means the rate quoted by the market maker will indicate two prices. One at which it is willing to buy the foreign currency, and the other at which it is willing to sell the foreign currency. For example, a Mumbai bank may quote its rate for US dollar as under:
USD 1 = Rs 48.1525/1650
More often, the rate would be quoted as 1525/1650 since the players in the market are expected to know the ‘big number’ i.e., Rs 48. In the given quotation, one rate is Rs.48.1525 per dollar and the other rate is Rs.48.1650. per dollar.
It will be obvious that the quoting bank will be willing to buy dollars at Rs 48.1525 and sell dollars at Rs 48.1650. If one dollar bought and sold, the bank makes a gross profit of Rs. 0.0125. In a foreign exchange quotation, the foreign currency is the commodity that is being bought and sold. The exchange quotation which gives the price for the foreign currency in terms of the domestic currency is known as direct quotation. In a direct quotation, the quoting bank will apply the rule: Buy low; Sell high.
There is another way of quoting in the foreign exchange market. The Mumbai bank quotes the rate for dollar as:
Rs. 100 = USD 2.0762/0767
This type of quotation which gives the quantity of foreign currency per unit of domestic currency is known as indirect quotation. In this case, the quoting bank will receive USD 2.0767 per Rs.100 while buying dollars and give away USD 2.0762 per Rs.100 while selling dollars. In other world, he will apply the rule: Buy high: Sell low.
The buying rate is also known as the bid rate and selling rate as the offer rate. The difference between these rates is the gross profit for the bank and is known as the Spread.
Spot and Forward transactions
The transactions in the interbank market may place for settlement
(a) on the same day; or
(b) two days later; or
(c) some day late; say after a month
Where the agreement to buy and sell is agreed upon and executed on the same date, the transaction is known as cash or ready transaction. It is also known as value today.
The transaction where the exchange of currencies takes place two days after the date of the contact is known as the spot transaction. For instance, if the contract is made on Monday, the delivery should take place on Wednesday. If Wednesday is a holiday, the delivery will take place on the next day, i.e., Thursday. Rupee payment is also made on the same day the foreign currency is received.
The transaction in which the exchange of currencies takes places at a specified future date, subsequent to the spot date, is known as a forward transaction. The forward transaction can be for delivery one month or two months or three months etc. A forward contract for delivery one month means the exchange of currencies will take place after one month from the date of contract. A forward contract for delivery two months means the exchange of currencies will take place after two months and so on.
Forward Margin/Swap points
Forward rate may be the same as the spot rate for the currency. Then it is said to be at par with the spot rate. But this rarely happens. More often the forward rate for a currency may be costlier or chapter tan its spot rate. The rate for a currency may be costlier or cheaper than nits spot rate. The difference between the forward rate and the spot rate is known as the forward margin or swap points. The forward margin may be either at premium or at discount. If the forward margin is at premium, the foreign correct will be costlier under forward rate than under the spot rate. If the forward margin is at discount, the foreign currency will be cheaper for forward delivery then for spot delivery. Under direct quotation, premium is added to spot rate to arrive at the forward rate. This is done for both purchase and sale transactions. Discount is deducted from the spot rate to arrive at the forward rate.