Introduction to Foreign Exchange

This is a detailed introduction to the topic of Foreign Exchange. I have discussed the following topics in this reading material.
  1. Role of forex in international payments
  2. Basics of foreign exchange
  3. Cross rate arithmetic
  4. FX Settlement
  5. FX deals
  6. Interbank rates and arbitraging
  7. Forward exchange
  8. Forex swaps
  9. Commercial transactions and foreign exchange
  10. Administration of FX in India (India specific)
  11. Foreign currency accounts
  12. FX trade lifecycle - more from operations perspective
  13. Accounting of FX transactions
  14. Continuous Linked Settlement (CLS)
  15. ISO Currency Codes - 4217

Role of forex in international payments

Foreign Exchange (Forex of FX) is the exchange of one brand of currency against another brand of currency. The primary reason for this exchange is international trade. Thus, as long as international trade happens, FX would be required. If international trade ceases to exist then FX would not be necessary. Alternatively, if all the countries in the world decide to adopt and use a single currency instead of so many currencies then also FX would cease to exist. We can see a glimpse of this practice in the way Euro Zone region has unilaterally adopted Euro as a single currency by shelving off their individual currencies. If the same where to take place across the world then FX would not be necessary. However, the happening of such a thing is only a remote dream for the reason that it is not so easy for countries to shelve off their currencies. Hence, until then FX would exist and we need to study this subject.

International trade exists for the following two reasons:
  1. Comparative advantage
  2. Competitive advantage
Comparative advantage:
All the countries in the world are not bestowed with all the natural resources. There is a disproportionate allocation of natural and personnel resources (minerals, talent, intelligence and other) across the globe. Due to this, no single country can be self-sufficient and have all that it wants. For example, Iron ore is available in abundance in some countries such as India, Brazil and Australia, while in many other parts of the world it is not sufficiently present. Thus, countries which have shortage of Ironore such as Japan, China, etc., would like to import it from countries where there is a surplus. This exchange of resources results in international trade.

Competitive advantage
Even if all the countries in the world are bestowed with all the natural resources, there would still be international trade. The reason is becasue of disproportionate allocation of personnel resources (talent, labour, capital, organisational skills, etc.) across the globe. For example, both US and China can manufacture electronic equipments such as computers, television sets, etc. However, it is cheaper to manufacture those in China instead of US, as labour is relatively cheaper in China. Similarly, India can manufacture pharmaceutical products and develop software cheaper than what US, UK or Europe can do. Thus, it makes financial sense to manufacture or develop those products or services in India instead of doing it elsewhere. Thus, competitive advantage ensures that international trade takes place.

For a trade to be called a Forex trade, it has to satisfy the following two criteria.
  1. There must be two currencies involved
  2. The exchange rate between the currencies must be fixed
Consider the following examples and determine whether they are FX trades.

A bank accepts a foreign currency time deposit from a customer at a fixed rate of interest. Is this a forex trade?
The answer is 'No'. In this example, the bank here accepts the deposit in foreign currency, pays interest in foreign currency and repays the principal, on maturity, in foreign currency. There is no involvement of two currencies and hence this is not a FX trade.

A bank opens a foreign currency import letter of credit (L/C) on behalf of its importer constituent in favour of a foreign supplier. Is this a forex trade?
The answer is 'No'. An L/C in foreign currency surely involves two currencies. However, at the time of opening the L/C, the rate of exchange between the two currencies is not fixed and thus it is not a FX trade. All that we can say is that this transaction would surely become a FX trasaction at a later point in time when the rate is fixed.

Thus, as discussed above, for any FX trade, both the criteria mentioned above must be met.

Before we discussed further on the FX transactions, let's discuss a few broad topics about the history and role of FX in international trade and payments.

Role of FX in International Trade and Payments
International trade refers to trade between the residents of two different countries. Each country is a soverign state with its own set of regulations and currency. Due to these differences, the following problems arise in conducting trade. The existence of national monetary units poses a problem in the settlement of international transactions. The exporter would like to get paid in the currency of his country, while the importer has its money balances in its local currency. A need, therefore, arises for conversion of the currency of the importer's country into that of the exporter's country. Foreign exchange is the mechanism by which the currency of one country gets converted ino the currency of another country.

The conversion of currencies is, mainly, done by banks who deal in foreign exchange. These banks maintain stock of foreign currencies in the form of balances with banks abroad. For example, State Bank of India (SBI) may maintain an account with Bank of America (New York Branch) in which it can maintain US dollar balances. When an Indian importer approaches SBI to help arrange a payment to a US exporter, SBI would use its US dollar balance held with Bank of America to make the payment.

In otherwords, the Indian importer would pay to SBI in India in Indian Rupees. SBI would use its US dollar balances with Bank of America to make the payment to the exporter. However, a rate of exchange between USD and INR would need to be fixed for this tranaction to happen, as the Indian importer is paying in INR, while SBI is making the payment in USD. This rate is called the 'Foreign exchange rate' or simply 'Exchange rate' or 'FX rate', in short.

FX Rate
FX rate is the rate at which one currency is converted into another. This rate is determined by the interaction between demand and supply in the foreign exchange market. Banks are the major participants in this market. The following are some of the factors which determine the FX rate.

Factors that determine the FX rate
The following factors, mainly, determine the FX rates.
  1. Balance of payments
  2. Inflation
  3. Interest Rates
  4. Money supply
  5. National income
  6. Resource discoveries
  7. Capital movements
  8. Political factors
  9. Psychological factors and speculation
  10. Technical factors

Balance of payments
Balance of payments is commonly defined as the record of transactions between its residents and foreign residents over a specific period. Each transaction is recorded in accordance with the principles of double-entry bookkeeping, meaning that the amount involved is entered in each of the two sides of the balance-of-payments accounts. Consequently, the sums of the two sides of the complete balance-of-payments accounts should always be the same, and in this sense the balance of payments always balances.

If looked from another angle, it represents the demand for and supply of foreign exchange which ultimately determines the value of the currency. Exports represent the supply side for foreign exchange (as exporters would earn their income in a foreign currency which they would want to sell for local currency as they will have to use local currency to make regular payments). Imports create demand for foreign currency (as importers would need to procure foreign currency for making import payments).

If the value of the exports are more than imports over a particular period of time, we call it as 'surplus'; if the opposite is true then we call it as 'deficit'. If the balance of payments of a country is continuously in deficit (that means, the value of its imports are more than exports), it implies that the demand for the currency of the country is lesser than its supply. Therefore, its value in the market declines. If the balance of payments is suplus continuously, it shows that the demand for the currency in the exchange market is higher than its supply and therefore the currency gains in value.

For example:
India's exports in 2018 is roughly USD 330 billion, while its imports are roughly USD 505 billion. Since imports are greater than exports, there is a deficit in balance of payments to the tune of USD 175 billion. India has been continously having a deficit in its balance of payments due to its dependence on oil imports. Thus, the Indian Rupee continuously loses value against major currencies.

Inflation refers to the general increase of prices of goods and services in a country. Increase in prices can make the exports costlier thereby reducing their competitiveness in the export markets. This will ultimately result in reduction in exports, which will result in the decrease in demand for the local currency, which will, in turn, result in decline in the value of the local currency. However, it may be noted here that it is relative rate of inflation between two countries that determine the exchange rate movement between the currencies of those countries. For example, if inflation in both USA and India is 10% per annum, then the exchange rate will not fluctuate due to inflation, as there is no relative difference in inflation. However, if the inflation is 5% in USA and 10% in India then the increase in prices would be higher in India than in USA and hence the Indian Rupee will depreciate relatively against US dollar.

Interest Rates
Inflation and Interest rates are closely linked to each other. Infact, they are inseperable or we can even say that they are one and the same. Interest rates have a great influence on the short term movement of capital. If interest rates in a particular country increases, it attracts short-term funds from other countries. This increases the demand for the local currency and thus results in increasing its value.

Interest rates can rise due to inflation or by deliberate policies of the central bank or government. Interest rates may be raised deliberately to attract foreign investment and/or to arrest the flow of outgoing investments. Irrespective of the intention, it results in strengthening the currency of the country, provided the foreign investments do come into the country. If the country's growth potential is not good or its credit standing is not good then increasing the interest rates do not result in attracting foreign investments.

Increase in interest rates will vary the exchange rate only when it is unilateral, unaccompanied by similar change in other countries.

Money Supply
An increase in money supply will lead to increase in inflation, which will result in reduction in exports and value of local currency.
An increase in money supply can increase spending on foreign goods, tourism, etc., thereby increasing imports, which reduces the value of the local currency against foreign currencies.

National Income
An increase in national income, in general, means increase in the income of the residents of the country. An increase in disposable income will lead to increase in demand for goods and services. This increase in demand can be met through two ways (1) increase in domestic production; and (2) increase in imports. It usually takes a bit of time for the domestic production to meet the increase in demand. Thus, in the short run, the increase in demand is met by imports. Imcrease in imports relative to the exports will case the local currency to depreciate. In the long run, increase in domestic production may also lead to increase in exports.

Resource Discoveries
When a country is able to discover new resources such as oil, gas, coal, precious metals, etc., then its currency value will increase in the international market. For example, discovery of North Sea oil by Britain helped the pound sterling to increase in value against USD to over USD 2.40 from USD 1.60 in just a few years. Similarly, new discoveries by USA, Canada and Russia helped to increase the value of their currencies.

Capital Movements
Capital movements (both short term and long term) are influeced by various factors such as short-term interest rates, long-term interest rates, liquidity, political stability, currency fluctuations, credibility, credit rating, transaparency, tax structure, ease of doing business, etc. The short term capital movements, however, are mostly to do with short term interest rates. If the short-term interest rates in a country increase relative to another country, we can expect some short-term capital movement into the country. This capital inflow will increase the exchange rate of the currency.

Political Factors
Political stability induces confidence in the investors and thereby encourages capital flow. The capital flow increases the value of the currency. The reverse is true in case of political instability. Any bad news on the government, leadership or policies will also have effect on the currency fluctuations. For example, Brexit event in UK has caused volatility in the pound against all major currencies in the world due to political uncertainity.

Psychological Factors and Speculation
Speculative activities based on greed and fear most often causes volatility in the exchange rates. Markets have their own expectations on various economic variables such as GDP, Balance of Payments (surplus or deficit), interest Rates, inflation, industrial production, unemployment, capital inflows and outflows, etc. The market players place their bets by assumption of a certain number for each of these variables. If the actual numbers (as per official statistics) differ widely from the assumed number then it will result in volatility in the exchange rates. In the short-run, these psychological factors and speculative bets have a big impact on the exchange rates. In the long run, the factors do not matter much.

Technical Factors
Factors such as large transactions, sudden lack of liquidity, government intervention such as exchange controls, probitions, etc., may also impact the exchange rates. Usually, these facors impact in exchange rates in the short run.

International Payment Systems
Settlement of international trade requires two elements: international money and an "adjustment" mechanism to correct the trade imbalances among nations. Experience shows that the first is less important and that the second has been the source of much trouble. The following paragaphs discuss the evolution of international payment systems, as it is through this system that trade payments are settled.

The following are the various international payment systems that existed over the last few centuries.
  1. Gold Standard (1870 - 1914)
  2. First Floating Rate Regime (1914 - 1925)
  3. Gold Exchange Standard (1925 - 1931)
  4. Controlled Float (1931 - 1939)
  5. Bretton Woods System (1944 - 1971)
  6. Smithsonian Agreement (1971 - 1973)
  7. Second Floating Rate Regime (From 1973)

Gold Standard (1870 - 1914)
Under the Gold Standard, central banks issued paper money and held gold (or silver or both) in reserve to back the paper money. The international payments system was built on the following features. The mint par rates of a national currency determined its value against other currencies. For example, if the mint par rates of US dollar was $100 and the mint par rate of Indian Rupee was Rs. 5,000 per unit of gold, then the dollar-rupee exchange rate would be Rs. 5,000/$100 = Rs. 50/- per dollar. The FX price would be fixed at this level irrespective of the demand and supply for the currencies.

As discussed above, there are two elements required in settlement of international trade - international money and adjustment mechanism. Under the Gold Standard method, Gld was that 'international money', which was used for settlement of trade between nations. The adjustment mechanism refers to the settlement method. The following describes that method.

Consider that in trade between USA and India, India has a trade deficit while USA has a trade surplus. In this case, India would have to ship out gold to USA to the extend of the deficit. This will reduce the money supply (stock) in India, causing deflation. This, in turn, will reduce imports but may help exports as prices would be cheap. The increase in exports coupled with reduced imports may result in trade surplus. This means that India will now received Gold from USA. The increase in Gold will led to increase in money supply (stock), causing inflation. This, in turn, may increase imports and reduce exports; which may again result in a trade deficit. The following diagram shows this adjustment mechanism.

Adjustment Mechanism under Gold Standard

The adjustment process was symmetrical in the sense that the country with trade surplus shared the burden of the country with trade deficit. The forex prices were fixed and stable. The central banks freely bought and sold gold at the mind par rate. This system was abandoned at the beginning of the World War I, to provide for expansion of money supply to meet war needs.

Contrary to popular belief, the Gold Standard was not a "100% bullion reserve" system, in which each banknote was 'backed' by an equivalent amount of gold bullion in a vault. In the United States in 1910, gold bullion reserves coverage was 42% of bank notes in circulation. Similarly, it was 46% in Britain, 54% in Germany, 60% in France, 41% in Belgium, 73% in Netherlands, 68% in Denmark, 80% in Finland, 75% in Norway, 75% in Switzerland, 55% in Russia and 62% in Austro-Hungary.

First Floating Rate Regime (1914 - 1925)
Except Switzerland, most countries suspended the gold covertibility for residents during 1914 - 1917, and the pre-war fixed exchange rates were maintained by mopping up gold and foreign securities from the residents.

After the war, the currencies were allowed to float during 1918 - 1925 and find their realistic financial strengths. The sterling pound fell from $4.86 to $3.40. The floating rate regime was intended as an interim arrangement, and the countries were to adopt such domestic policies as would restore the pre-war exchange rate and gold standard.

Gold Exchange Standard (1925 - 1931)
As discussed above, the Gold Standard broke down during World War I, as major belligerents resorted to inflationary finance, and was briefly reinstated from 1925 to 1931 as the Gold Exchange Standard. Britain restored gold stardard in 1925, and the pound-dollar rate was brought to the pre-war rate of $4.86.

Under this standard, countries could hold gold or dollars or pounds as reserves, except for the United States and the United Kingdom, which held reserves only in gold. Over 30 other countries established gold parities or fixed the exchange rate of their currencies with sterling pound.

This standard broke down in 1931 following Britain's departure from gold in the face of massive gold and capital outflows. Also, many countries pursued domestic policies that were unilateral and mercantilist, which did not fit in the automatic and symmetric adjustment mechanism under Gold Standard. The Great Depression of the late 1920s, too aided the collapse of gold exchange standard. Many converted their sterling pound into gold, leading to a run on the Bank of England's gold reserves.

Controlled Float (1931 - 1939)
Britain suspended the gold convertibility of sterling pound in 1931. In 1933, President Franklin D. Roosevelt nationalised gold owned by private citizens and abrogated contracts in which payments was specified in gold. Thus, by 1933, over 30 countries went off gold standard. Germany imposed exchange controls on its current account.

It was a period of chaos: there was the "sterling block" of Britain and her colonies, struggling to prop up sterling; there was the 'gold block' of Switzerland, Holland, France, Italy, Belgium, Luxembourg and Poland, struggling with their overvalued currencies; there was cental European countries struggling with German recovery and reaarmament; and there was the United States in economic isolation and lifting itself out of the Great Depression. In general, the exchange rates were floating for the second time.

Unlike the floating rate system in 1914 - 1925, however, the floating now was controlled by national governments to protect their domestic policies. Mostly, the control meant devaluation of currencies to achieve trade competitiveness. Out of this chaos came Bretton Woods System.

Bretton Woods System (1944 - 1971)
Bretton Woods System was built on the gold-convertibility of US dollar. It was officially described as "fixed rate regime with managed flexibility" and was popularly called "adjustable peg".

About 730 delegates from 44 allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States, for the United Nations Monetary and Financial Conference, also known as the Bretton Woods Conference. The delegates deliberated on setting up an international monetary system, and in the process created two important institutions: International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), which is also known as Wold Bank.

The United States, which controlled two-thirds of the world's gold, insisted that the Bretton Woods system rest on both gold and US dollar. Soviet representatives attended the conference but later declined to ratify the final agreements, charging the institutions they had crated as "branches of Wall Street". These organisations became operational in 1945 after a sufficient number of countries had ratified the agreement.

It is the Bretton Woods system that replaced gold standard with the U.S. dollar as the global currency. By doing so, it established America as the dominant power in the world economy. After the agreement was signed, America was the only country with the ability to print dollars.

The following were the features of the system.
Under the Gold Standard system, countries were not able to print their currencies more than the gold reserves they held. However, to meet the war costs (World War I), many nations abandoned the system. This allowed them to print currencies to meet the war costs. It caused hyperinflation, as the supply of money overwhelmed the demand. The value of money fell so drastically that, in some cases, people needed wheelbarrows full of cash just to buy a loaf of bread. After the war, countries returned to the safety of the gold standard. All went well until the Great Depression. After the 1929 stock market crash, investors switched to forex trading and commodities. It drove up the price of gold, resulting in people reedeeming their dollars for gold. The Federal Reserve made things worse by defending the nation's gold reserves by raising interest rates.

The Bretton Woods System, as discussed above, tried to overcome the limitations of the Gold Standard by giving nations more flexibility than a strict adherence to the gold standard. It also provided less volatility than a currency system with no standard at all. A member country still retained the ability to alter its currency's value if needed to correct a "fundamental equilibrium" in its current account balance.

The US consciously ran trade deficit to enable other countries to build up reserves in dollars, which was gold-convertible and hence 'good as gold'. As a result, the value of the dollar began to increase relative to other currencies. There was more demand for it, even though its worth in gold remained the same. This discrepancy in value planted the seed for the collapse of the Bretton Woods system three decades later.

During the second half of the 1960s, the US suffered Vietnam War, worsened trade deficit and inflation. To contain the inflation, dollar interest rates were hiked, which attracted further capital into the US. In a way, the US was importing goods and exporting inflation, which prompted the French President to as: what stops America from printing dollars and buying up France?

It has reached a stage where the US gold reserves were insufficient to meet the gold-convertibility of dollar. Free market price of gold went above the official price of $35 a troy ounce. In 1971, the United States was suffering from massive stagflation (a deadly combination of inflation and recession). Some countries such as France converted their dollar reserves into gold for political (and practical) reasons. Canada abandoned the adjustable peg of Bretton Woods System and allowed its currency to freely float. In response, President Nixon started to deflate the dollar's value in gold to 1/38 of an ounce of gold, then to 1/42 of an ounce. But the plan backfired. It created a run on the U.S. gold reserves at Fort Knox as people redeemed their quickly devaluing dollars for gold. In 1973, Nixon unhooked the value of dollar from gold altogether. Without price controls, gold quickly shot up to $120 per ounce in the free market, ending the Bretoon Woods System.

Smithsonian Agreement (1971 - 1973
The chaoas in the aftermath of the collapse of Bretton Woods System brought the top central banks together and resulted in Smithsonian Agreement, which was a highly diluted version of the Bretton Woods System. It was called the 'Smithsonian Agreement' because it was conducted at the 'Smithsonian Institute' in Washington D.C, United States., by the G-10 countries.

Under this agreement, the Nixon Administration decided to devalue dollar against gold from $35 to $38 a troy ounce without providing gold convertibility. It also established a trading band of +/- 2.25% around the peg rate. Other currencies were revalued (mostly appreciated) against the dollar, such as Yen by +16.9%, Deutsche Mark by +13.6%, French Franc by +8.6%, British Pound by +8.6%, Italian Lira by +7.5%, etc. Canada continued to float its currency.

However, strains developed in the system soon after it was introduced. Speculators pushed many foreign currencies up against their now-higher valuation limits, and the value of gold was driven higher as well. When the U.S unilaterally decided to devalue its dollar by 10% in Febrary 1973, raising the price of gold to $42 per troy ounce. This was good much to bear for the system. Britain left the system in 1972, others followed soon after and ended the agreement just after 18 months of its start.

Second Floating Rate Regime (From 1973 onwards)
After the collapse of the Bretton Woods Agreement in 1971, the Gold Standard disappeared. In 1978, the second Amendment to the IMF Articles barred its members from fixing their currency parities to gold, and it eliminated the obligation to buy and sell gold at the fixed parities. With this, gold was officially eliminated from the international monetary system. Switzerland continued to backed gold (to a minimum extent) until the year 2000, when it also finally abolished the link between Swiss Franc and Gold. With this, gold ceased to have any role in any monetary systems (domestic or international) - officially.

Since 1973, all currencies are on "floating rate regime", which is also called as 'fluctuating or flexible exchange rate'. Under this regime, the value of a currency is free to fluctuate in response to foreign-exchange market events. To enable international trade, all currencies must be convertible on trade account (trade account and capital account are two types of accounts under Balance of Payments, a topic that we shall discuss later in this reading material). To conserve reserves, governments may impose trade controls to limit the convertibility but not stop it altogether. Convertibility on capital account is generally restricted because capital flows (both inflow and outflow) are considered the source of forex rate instability.

The forex regime today can be characterized by three features: forex rate, reserve asset and capital account convertibility. The following table shows this mix.

Rate Mechanism Reserve Asset Capital Account Convertibility
Free Float Convertible Currencies Free
Managed Float SDR Regulated
Gilding Peg Gold Dual
Fixed Peg Mix of the above Mix of the above

The above are some of the various regimes that have existed since the year 1870. Currently, most countries are in "Free Float" regime and a few are in the "Managed Float".

Which Regime is the best?
There is no definite answer. Every regime worked well for sometime under some circumstances, and no system worked well for all times and in all circumstances. However, we can say that the current "floating rate" regime is the best of the lot, though it is complex to operate or maintain. In general, we make out the following.

Basics of Foreign Exchange

Currency Pair
Every forex transaction is a currency pair, and the forex price is the price of one currency in terms of another. In our daily life, we deal with the following types of exchanges.
  1. Barter: Exchange of goods for goods
  2. Money: Exchange of goods for money
  3. Forex: Exchange of money for money
Forex is the third types of exchange where we exchange one brand of currency for another brand of currency.

Base Currency and Quoting Currency
Of the two currencies in a forex pair, one of them is called the base currency and the other, the quoting currency or variable currency.

Consider the following forex quote:
Currency Pair Price (Exchange Rate)
USD / INR 70

In the above quote, there are two currencies that are mentioned - USD and INR. USD stands for United States Dollar and INR stands for Indian Rupee. The first currency in the quote is USD and the second currency in the quote (mentioned after the forward slash "/") is INR. The first currency mentioned in the quote (USD) is called as the Base Currency and the second currency mentioned in the quote (INR) is called as the Quoting currency (or Variable currency). Base Currency is the currency that is priced in the quote. In otherwords (in a limited sense for our easy understanding), we can think that what is being bought or sold is the base currency (i.e. USD in the quote) and the price of one USD is INR 70.

In reality, both USD and INR are being bought and sold simultaneously. For example, the above quote can also be interpreted as 1 INR = 0.01428 USD. This is arrived by simply dividing 1 by 70.

However, we shall stick to the quote literally and interpret it in the way it is written - i.e. what is being sold is the base currency and its price is mentioned in terms of variable currency. This statement always holds true in all quotation styles and must be memorised. \[ Forex \; Price \; = Price \; of \; Base \; Currency \; in \; Quoting \; Currency \] The amount of base currency is fixed (usually at one unit).

ISO stands for "International Organisation for Standards" and SWIFT stands for "Society for Worldwide Interbank Financial Telecommunications".

ISO has given a three-letter code for every currency in thier ISO 4217 standard. The first two letters are the country code defined by ISO in their standard (ISO 3166) and the third letter is usually, but not always, the first letter of the currency name. The following table shows the ISO codes for some currencies. For a complete list of all the currencies, please vist my notes titled ISO Currency Codes - ISO 4217.

ISO Codes for Major Currencies
Country Currency ISO Code
United Kingdom Pound GBP
European Union Euro EUR
United States Dollar USD
Switzerland Swiss Franc CHF
Japan Yen JPY
India Rupee INR
China Renminbi CNY
South Africa Rand ZAR

The ISO codes are adopted by SWIFT, which is the communication and messaging network for banks the world over. Only these ISO/SWIFT codes, and not symbols or special characters (e.g. $, £, ¥, €) must be used in any standard forex messaging.

The market practice for the notation of a currency pair is to write the Base Currency code first, followed by the Quoting Currency. The following table shows this market practice.

Currency Pair Base Currency Quoting Currency Forex Price

Exceptions in the ISO Codes
As discussed above, in general, the first two digits in the ISO code represents the country code and the last digit represents the first letter of the currency. For example, in USD, "US" refers to United States and "D" refers to Dollar; in JPY, "JP" refers to Japan and "Y" refers to Yen; in INR, "IN" refers to India and R refers to "Rupee", and so forth. However, there are some currencies for which this method or trend is not followed by ISO. These are the exceptions and the following are some of them, along with the probably reasons.

Exceptions in ISO Codes
Currency Exceptions
United Kingdom ISO assigned "GB" as the country code to the United Kingdom and reserved the word "UK". Great Britain refers to the island of Britannica, which contains England, Scotland and Wales. United Kingdom contains the countries of Great Britain and Northern Ireland.
Switzerland Switzerland's official name is "Confoederatio Helvetica (Helvetica Confederation)". Thus, ISO has allocated the "CH" words instead of "SW".
South Africa South Africa was once ruled by Dutch, and its Dutch name was Zuid-Africa. Thus, ISO allocated "ZA" instead of "SA"
Euro Europe's Euro should have been represented as "EUE". However, ISO gave the words "EUR"; probably because "EUE" is hard on the tongue.
Chinese Renminbi In communist China, everything is "people's: people's republic, people's army, people's money (renminbi). However, the currency is also known as same Yuan. Thus, in China, there are two names for the currency - Renminbi for domestic purposes and Yuan for international purposes. ISO has given the word "Y" to represent Yuan.
Precious Metails For precious metals, the ISO currency codes starts with the letter "X", followed by the chemical name for the metal. For example, XAU is for Gold (AU is Aurum in Latin for Gold), XAG is for Silver (AG is Argentum in Latin for Silver)
Supranational Currencies For supranational currencies, the ISO currency code starts with the letter "X", followed by the currency name. For example, for Special Drawings Rights of IMF, the currency code is XDR; for East Carribean Dollar, the ISO currency code is XCD.

Heirarchy in the Currency Pair
Which currency should be the base currency in a currrency pair? The following is the order of precedence among the major currencies. Whenever GBP is involved in a currency pair, it will always be the base currency. Whenever EUR is involved in a currency pair, it will always be the base currency against all other currencies in the world, except when the other currency is GBP. The following is an example on this for better clarity.

The above order of precedence has nothing to do with the value of the currency or the strength of the economy. It is due to historical reasons and the non-metric subdivision of currencies. The following explains the reasons.

The most important currency of the present time is USD. Thus, one would generally be interested to know the price of other currencies against USD. This is, indeed, true for most currencies in the world except four currencies (as stated above) i.e. GBP, EUR, AUD and NZD. The reason for this is the non-metric subdivision of pound.

Before and during the 18th century (particularly in 1799 during the French Revolution), a new system called as "metric system" started to develop mostly in France. In this system, the base units were taken from the natural world: the unit of length (metre) was based on the dimensions of the earth, and the unit of mass (killogram) was based on the mass of water having a volume of one litre, etc. Thus, under this system, the base units were first defined and all other units of measure, called "derived units", were defined in terms of the base units. This system was not widely used during that time by all the countries. It took time to refine this system and to be finally accepted by all and thereby introduced as an international standard. Prominent scientists such as James Clerk Maxwell, Carl Friedrich Guass, James Watt and a few others were instrumental in making this an international standard.

During this period, the pound was under the non-metric system, which divided it as librae, solidi, dinarii (Latin for pounds, schillings, pennies). The subdivision was: £1 = s20 = p240. Value of less than one pound must be expressed in schillings; and value of less than a schillings, in pennies. If USD 1 = GBP 0.6250, for example, it must be expressed as 0-12-6, which is intuitively cumbersome. The complexity increases if the value of pound changes. For example, if the price changes to GBP 0.6255, then the new price would be 0-12-6.12. To avoid this cumbersome notation, GBP is made the base currency so that its amount is always fixed as one unit. Though the UK switched over to the metric system in the early 1970s (under which one pound is 100 new pence), the market practice continued.

In case of AUD and NZD, the exception was due to the colonial past. What England does, the colonies would simply copy them. The reason for EUR's case was that the forex market expects the EUR to eventually replace USD as the international reserve currency. Ahead of such development, the market made the EUR as the base currency when it was introduced in 1999.

N Currencies and N-1 Currency Pairs
If there are N currencies to start with, how many currency pairs are possible. The reason we need to know this is because forex transactions deal with currency pairs. There are about 250 countries in the world. If everyone had their own soverign currency, we would need to know how many currency pairs we would have to deal with. To understand this, we can arrange a sample number of currencies in a rectangle as below and find out the combinations possible.

N Currencies

In the above diagram, we are assuming that the letters A, B, C, D and E represent a particular currency. They are arranged as row headings and column headings. Each cell is a currency pair. For example, "A/A" is a currency pair, "A/B" is a currency pair and son on. If we have to know the total number of cells possible (currency pairs) then we have to multiply the total number of rows with the total number of columns. In the above diagram, the total number of cells possible would be N x N = N2. This we can call it as the total number of permutations possible including repetition.

However, we are not interested in the total number of currency pairs possible. A currency pair such as "Dollar vs Dollar (USD/USD)" or "Euro vs Euro (EUR/EUR)" has no meaning in forex. We need to have two different currencies in a forex transaction not the same currencies. Thus, we need to exclude such currency pairs. In the above diagram, the diagonal represents currency pairs which have the same currencies and thus are irrelevant. In otherwords, we are interested to find out the total number of permutations possible without repetitions. We can find this by the formula N x (N - 1).

Even now, we did not get the answer that we are looking for. A closer look at the diagram will reveal that the in the permutations, we have currency pairs such as "B/A" and "A/B". We can think of this as "USD/EUR" and "EUR/USD". That means, they are the same currency pairs represented differently. Since they mean the same, we are not interested in such repetitions. In the diagram above, you can see that above the diagonal (which is coloured in light orange), the cells are a mirror reflection of the cells that are below the diagonal. Thus, we are only interested in half of the rectangle or cells below the diagonal. In otherwords, we are interested only in finding combinations. The formula for that would be [N X (N - 1) / 2].

The world has about 150 currencies, which results in 11,175 {(150 x (150 - 1) / 2} currency pairs. It is not practically possible to deal with such a large number of currency pairs. To make the actual number of currency pairs smaller and manageable, the concept of numeraire currency was introduced.

Numeraire Currency
Under the concept of Numeraire currency, a single currency is designated as Numeraire currency and all other currencies are priced against it. For example, out of the 150 currencies (as discussed above), we can select one currency (e.g. USD) as the numeraire currrency and the rest 149 currencies are priced against it. Thus, instead of dealing with 11,175 currency pairs, we would have to only deal with 149 currency pairs. This would be easy for dealers and traders to operate in the market.

Which among the N currencies should be the numeraire currency? It depends on the market segment, as described below.

Market Segments in Forex
There are two segments in the foreign exchange market. They are:
  1. Interdealer market (also called interbank market)
  2. Commercial market

Interdealer market
In the interdealer market, both the parties are dealers. Most of the dealers are banks and thus it is also commonly referred to as the interbank market.

The following are the features of the interdealer market. The numeraire currency in the interdealer market has been different in different times. Venetian Ducat (the currency in The Merchant of Venice), Florentine Florine, Dutch Guilder, German Thaler and British Pound have successfully served as numeraire. Currently, the numeraire is US dollar. In future, it can be Euro.

Currency pairs not involving USD (e.g. GBP/EUR, EUR/JPY, GBP/CHF, etc) are called as "Cross Rate", which are not directly quoted but derived by "crossing" two USD-based rates. This concept is explained later.

Commercial Market
In the commercial market, one party is a end user (such as exporters, importers, remitters, tourists, etc) while the other is a dealer (usually banks). The end users sell and buy foreign currencies against the home currency. The following are the features of the commercial market.
The numeraire currency in the commercial market is the local currency, as the end users would want to know the value of all foreign currencies against the local currencies that they hold. The examples of currency pairs in this market are USD/INR, GBP/INR, CHF/INR, SGD/INR, etc. As we can see, many of these currency pairs are cross rates.

Cross Rates
Cross rates are currency pairs that do not contain the interdealer numeraire currency (i.e. currently USD). Examples of such rates are GBP/EUR, EUR/CHF, CHF/INR, AUD/CHF, etc. These rates are obtained by crossing two numeraire (or USD) based rates. For example, CHF/INR rate can be obtained from USD/CHF rate and USD/INR rate. The crossing here means division or multiplication. This topic is covered in a separate section later in this reading material.

The main difference between the numeraire rates and cross rates is that the price of the numeraire currency is determined by demand and supply, while the price of the cross rate is determined by arbitrage arithmetic. If one of the underlying rates change, the cross rate must change, regardless of whether the demand and supply situation changes.

Quotation Styles
There are two ways in which a particular product can be quoted - price based or volume based. The following shows the types.

Both of the above styles involve buying and selling of apples. In the first, what is quoted is the price of a single apple (or product) and thus is called as "price quotation". In the second, what is quoted is the volume of apples one can purchase for a certain amount of money and thus is called as "volume quotation". In both the quotation styles, the quantity on the left hand side (unit of products or amount of money) is fixed, and that on the right hand side is negotiated.

Price quotation is also called the "direct" style of quotation because from it we can directly and easily understand the price of a unit of product. The Volume quotation is also called as the "indirect" style of quotation because we need to derive (by doing some simple calculation) the price of the product. In the direct (price) quotation, we will have to "buy low and sell high" inorder to make profit. In the indirect (volume) quotation, the we will have to "buy high and sell low" in order to make profit.

In the forex market, whether the quotation style is direct or indirect depends on the market segmenet. In the interdealer market, if the base currency is the numeraire currency (i.e. currently USD) then the quotation style is direct; else, indirect. In the commercial market segement, if the base currency is the foreign currency, then the quotation style is direct; else, indirect. The following table explains this concept better.

Quotation Styles Interdealer market
(numeraire = USD)
Commercial market
(numeraire = local currency)
Direct style Numeraire = Base Currency
Numeraire = Quoting Currency
Indirect style Numeraire = Quoting Currency
Numeraire = Base Currency

Irrespective of the quotation style, what is quoted is always the price of the base currency in quoting currency.

Usually, the base currency is always kept at one unit. However, in some cases the forex price is so low that the price needs to be quoted in more than six decimals. In such cases, it is convenient to keep the base currency amount at 100 units (or even more, if required) and truncate the quote to four (or fewer) decimal places. For example, consider the quote JPY/INR = 0.645307. Instead of this, it is convenient to quote as 100 JPY = 64.53.

Two Way Quotes
In the interdealer market (interbank market) the participants are dealers - i.e. they buy and sell currencies. They quote both buy and sell prices. The buy-sell price of the dealer is also called as bid-offer (or bid-ask price in the US market). The two-way quote (by quoting both bid and ask prices) enable the dealers to buy and sell currencies simultaneously. As discussed earlier, in a forex deal, both the currencies are bought and sold simultaneously.

When a quote is made by the dealer, we call the dealer the "price maker", and the person to whom it is shown as the "price taker". Consider the following two-way quote of a dealer.

EUR / USD = 1.6000 / 1.6005
The following points must be remembered in a quote like the above. The following diagram summarizes the anatomy of the two-way forex quotes.

FX Two Way Quote - Price Maker and Price Taker

Abbreviated Offer Side
The offer (or second or right hand) side of the two-way quote is not quoted in full but abbreviated. Only the last two digits are quoted. For example: 1.6000 / 1.6005 is abbreviated to 1.6000 / 05
1.9997 / 2.0002 is abbreviated to 1.9997 / 02

There is a rule for abbreviation of quotes: the offer side (second side) will have the same number of decimals as the first side.

In the first quote above, the 1.6005 is abbreviated by quoting only the last 2 digits after decimal, i.e. '05'. Even though abbreviated, it is easy to make sense of the quote (1.6000 / 05) because, as stated in the rule above, 05 should mean 1.6005. However, in the second quote above, 2.0002 is abbreviated to 02. To make sense of the quote, we need to be attentive to the fact that the offer price (ask price) cannot be lesser than the bid price. Thus, in the abbreviated quote 1.9997 / 02, the offer side cannot be 1.9902, it has to be more than 1.9997, and the immediate number that can be such is 2.0002.

Cross Rate Arithmetic

As discussed in the section on "numeraire currency", cross rates are those rates which do not involve the numeraire currency, i.e. USD. For example, GBP/EUR, GBP/CHF, EUR/JPY, EUR/INR, etc., are cross rates.

The cross rates can be derived by using two numeraire rates, and this involves the use or arithmetic, commonly referred to as "cross rate arithmetic".

Let us consider the following example.

We are required to find out the rate between EUR/INR, we are given the following rates:
EUR/USD = 1.1
USD/INR = 70

Without using any formula or known method, we can get the cross rate by using the following logic.
We can think that we have EUR 1 in our pocket and we want to exchange this for INR. We do not have any direct exchange rate to know the amount of INR we will receive. However, we can first convert our EUR into USD and then convert the USD into INR, as we know their exchange rates. The first quote of EUR/USD = 1.1 means 1 EUR = 1.1 USD. By using this quote, we can exchange our EUR 1 and get USD 1.1. Now, we can use the second quote to convert our USD to INR. The quote of USD/INR = 70 means 1 USD = 70 INR. However, we have 1.1 USD with us now, If 1 USD = 70, then 1.1 USD = 77 (70 x 1.1) INR. By exchanging twice, in the above example, we were able to convert our EUR 1 into INR 77. Thus, we can say that the exchange rate between EUR and INR is 77. This is the cross rate.

As we saw above, we can use a simple logic of using the two numeraire rates to get out cross rate.

To make things simple in calculating the cross rate, we also have a popular method called the "Chain Rule Method". The following explains the method.

Chain Rule Method
One apple is INR 20 and one banana is INR 4. One apple is worth how many bananas? We can say instantly that one apple is worth five bananas because the solution is intuitive. Let us consider a similar situation. Three roses are INR 5 and seven lotuses are INR 25. One rose is worth how many lotuses? The solution does not strike immediately because it is not very intuitive. When intuition fails, we apply logic. Chain rule is that logic and the principle of cross rate arithmetic.

Chain rule consists of the following four steps:
  1. Define the cross rate in the proper format
  2. Identify the two underlying rates
  3. Arrange the underlying rates to form a chain
  4. Multiply and divide
The following are some examples on cross rate arithmetic.

Example - 1
We are required to find CHF/INR, we are given the following rates:
USD/INR = 70
USD/CHF = 0.9823

The above information should be arranged in the following order.
CHF 1 = ? INR (This is the required cross rate. Let's call it as "Rate Format 1").
INR 70 = 1 USD (This is the underlying rate. We can call this as "Rate Format 2". This is arranged in such a manner that the currency which ends in Rate Format 1 will start in Rate Format 2).
USD 1 = 0.9823 CHF (This is the underlying rate. We can call this as "Rate Format 3". This is arranged in such a manner that the currency which ends in Rate Format 2 will start in Rate Format 3).

As we can see, what ends in one rate format, starts in the another; thus, forming a chain. Hence, the name "chain rule method"

We can visualize this as follows.

FX Cross Rates

Once we are done with arranging of the quotes, we need to use arithmetic to find the cross rates. The arithmetic is that we need to take the product of the left-hand side of the equation and divide it by the right-hand side of the equation.

In the above example, the arithmetic is as follows:

\[ { 1 \text { x } 70 \text { x } 1 \over 1 \text { x } 0.9823 }= 71.2613 \]
Thus, the exchange rate between CHF and INR is 71.2613 (CHF/INR = 71.2613).

Example - 2
We are required to find EUR/INR, we are given the following rates:
EUR/USD = 1.11089
USD/INR = 69.7121

The above rates should be arranged in the following order.
EUR 1 = ? INR
69.7121 INR = 1 USD
1.11089 USD = 1 EUR

Now, the cross rate can be calculated as follows:
\[ {1 \text { x } 69.7121 \text { x } 1.11089 \over 1 \text { x } 1} = {77.4424 \over 1} = 77.4424 \]
Thus, the EUR/INR = 77.4424.

Example - 3
We are required to find JPY/INR, we are given the following rates.
USD/INR = 69.7121
USD/JPY = 106.590

If the quantity of base currency JPY is 1 then the value of the rate will be so low that we will have to quote the rate up to 6 or 8 decimals. To avoid such lengthy, cumbersome quotes, the market convention for JPY/INR currency pair is to keep the base currency unit at 100 instead of 1.

The above rates should be arranged in the following order.
JPY 100 = ? INR
INR 69.7121 = 1 USD
USD 1 = 106.590 JPY

Now, the cross rate can be calculated as follows: \[ { 100 \text { x } 69.7121 \text { x } 1 \over 1 \text { x } 106.59 } = { 6971.21 \over 106.59 } = 65.4021 \]
Thus, JPY/INR = 65.4021

Example - 4
We are required to find EUR/SAR. SAR stands for Saudi Arabian Riyal. We are given the following rates.
EUR/USD = 1.11089
USD/SAR = 3.7500

The above rates should be arranged in the following order
EUR 1 = ? SAR
SAR 3.7500 = 1 USD
USD 1.11089 = 1 EUR

Now, the cross rate can be calculated as follows: \[ { 1 \text { x } 3.7500 \text { x } 1.11089 \over 1 \text { x } 1 } = 4.16583 \]
Thus, EUR/SAR rate is 4.16583

Cross Rate Arithmetic with Two-Way Quotes
The arithmetic with one-sided quotes is simplistic and has only illustrative value. In practice, we always deal with two-way quotes, which imposes the additional requirement of whether we should cross the same or opposite sides of the underlying two-way quotes. The following examples illustrates the arithmetic invovled.

Example - 5
We are required to find EUR/INR, we are given the following rates.
EUR/USD = 1.11089 / 95
USD/INR = 69.7121 / 29

We must first expand the abbreviated quotes to understand it better. The following is the expansion.
EUR 1 = USD 1.11089 / 1.11095 (Let's call this as Euro Quote)
USD 1 = INR 69.7121 / 69.7129 (Let's call this as Dollar Quote)

Now, the way to solve this problem is to think that the dealer would offer the cross rate on the basis of hedging or covering. This means that if the dealer is buying something on the cross rate then he would immediately sell it on the numeraire rate. Similarly, if he is selling something on the cross rate then he would immediately buy it on the numeraire rate. He would do so to hedge his position.

The other way to solve the problem intuitively is to simply use the numerarire rates to arrive at the cross rate (as explained in Example 1 above, but now using the two-way quotes). We shall try to solve this problem by take two positions - in one we would be selling EUR and in another we would be buying EUR.

Let's think that we have 1 EUR in our pocket and we went to a dealer to exchange it for INR. The dealer has given the above underlying quotes. We do not have the exchange rate directly but we can get to it by using the underlying rates that are given to us. As per the Euro Quote, we can exchange our 1 EUR at the dealer's Euro buying rate i.e. 1.11089 USD. Thus, we can sell our 1 EUR and get 1.11089 USD. (Note: As per the Euro Quote of the dealer, he buys 1 EUR at 1.11089 USD and sells 1 EUR at 1.11095 USD.

We have 1.11089 USD with us now; but we want INR. We can use the Dollar quote and exchange our USD for INR. As per the Dollar quote, we can exchange 1 USD and get 69.7121 INR. (Note: As per the Dollar quote of the dealer, he buys 1 USD at 69.7121 INR and sells 1 USD at 69.7129 INR).If we exchange 1.11089 USD then we will get 77.4424 INR.

We started with selling 1 EUR and ended up with 77.4424 INR. Thus, one of the rates in the two that is required is 77.4424. But what is this rate - bid or ask?. Remember, we are the price takers in this example, we started by selling EUR to the dealer, which means the dealer is buying EUR. Hence, in the required quote of EUR/INR, the rate of 77.4424 that we obtained is the dealer's buying rate or the bid rate. We will try to get the dealer's ask rate by buying EUR. This is explained as below.

Let's think that we have 100 INR in our pocket and we want to buy EUR. (Note: It does not matter what amount of INR is there in your pocket. We can use 69.7121, 69.7129 or any other number. The concept is important, the number is not. The arithmetic will remain the same, the result will be different). We cannot buy EUR through a direct quote as there is none. We can use the Dollar Quote to exchange our INR and get USD. As per the Dollar Quote, we can sell (we are the price takers here) 1 USD at 69.7121 INR and buy 1 USD at 69.7129 INR. If we are selling INR then we are buying USD. Our buying rate as per the dealer's quote would be 69.7129 (dealer's selling rate). The rate means that we can sell 69.7129 INR and buy 1 USD. If we sell 100 INR, we will get {(100 x 1)/69.7129} = 1.434455 USD.

We have 1.434455 USD with us now. But we want EUR. We can use the Euro Quote to exchange our USD for EUR. If we are selling dollars that means we are also buying EUR. Our Euro buying rate = dealer's Euro selling rate, which is 1.11095 USD. If we sell 1.11095 USD then we get 1 EUR. If we sell 1.4344 USD, we will get (1.434455 / 1.11095) = 1.29119 EUR.

So, we started by selling 100 INR and ended up with 1.2911967 EUR. Thus, 1 EUR = 77.4475 INR. Since we are buying EUR, the dealer is selling EUR, and hence this is the dealer's ask price.

We can now say that the cross rate between EUR/INR = 77.4424 / 77.4475. We can abbreviate this 77.4424/75.

Check on Caluclations
One obvious check on the correctness of the calculations is that the bid price must be lower than the offer price. This is necessary but not a sufficient condition. The additional check is that the bid-offer spread in the cross rate must be equal to the sum of spreads in the bid-offer in the two underlying rates. This must be so because the cross rate is derived from the two underlying rates and therefore combines the spreads in its bid-offer.

We cannot straightaway add the two spreads in the underlying rates because they are apples and oranges. The spread of 0.00006 on the EUR/USD quote is on a base of 1.11089/95; while the spread of 0.0008 is on a base of 69.7121/29. To be comparable, we must convert them into percentages of the mid rate of bid-offer. The following table shows the calculation.

Currency Pairs Bid Offer Spread Mid Price Spread Percentage
EUR/USD 1.11089 1.11095 0.00006 1.11092 0.0054%
USD/INR 69.7121 69.7129 0.0008 69.7125 0.00114%
Total of the underlying rate spreads = 0.00654%
EUR/INR 77.4424 77.4475 0.0051 77.44495 0.00658%
The slight difference in the spreads is due to rounding off errors.

The above logic is for conceptual understanding purposes. In practice, it will take a long time and practice to perform the calculations quickly. There exists a short-cut method to perform these calculations. The short-cut method is based on the following scenarios.
  1. Both currencies in cross rate are quoting currencies in thier source.
  2. Both currencies in cross rate are base currencies in their source.
  3. One currency in the cross rate is the base currency and the other is quoting currency in its source.
    1. Base currency of cross rate is the base currency in its source.
    2. Base currency of cross rate is the quoting currency in its source.
1) Both currencies in cross rate are quoting currencies in their source.
In this scenario, the following is the rule:

Pair the opposite sides and divide, the numerator being the source rate containing the quoting currency of the cross rate.
Let's understand this through the help of an example. Let's assume that we are required to find CHF/INR, the underlying rates are:
USD/INR = 72.3128 / 72.3642
USD/CHF = 0.989762 / 0.991732
The way to calculate this quickly, is to arrange the quotes in the following manner and use the cross rate arithmetic.

Traders Quick Method - 1

In our example, we can arrange our rates in the following manner.

Currency Pairs Bid Rate Ask Rate
USD/INR 72.3128 72.3642
USD/CHF 0.989762 0.991732

Therefore: \[ CHF/INR \text { (Bid) } = {72.3128 \over 0.991732} = 72.9156 \] \[ CHF/INR \text { (Offer) } = {72.3642 \over 0.989762} = 73.112728 \]

2) Both currencies in cross rate are base currencies in their source.
In this scenario, the following is the rule:

Pair the opposite sides and divide, the numerator being the source rate containing the base currency of the cross rate.
Let's understand this through the help of an example. Let's assume that we are required to find EUR/AUD, the underlying rates are:
EUR/USD = 1.5775 / 1.5779
AUD/USD = 0.7859 / 0.7961
The way to calculate this quickly, is to arrange the quotes in the following manner and use the cross rate arithmetic.

Traders Quick Method - 2

In our example, we can arrange our rates in the following manner.

Currency Pairs Bid Rate Ask Rate
EUR/USD 1.5775 1.5779
AUD/USD 0.7859 0.7961

Therefore: \[ EUR/AUD \text { (Bid) } = {1.5775 \over 0.7961} = 1.98153 \] \[ EUR/AUD \text { (Offer) } = {1.5779 \over 0.7859} = 2.00776 \]

3 (a) One of the currency in the cross rate is base currency and the other is quoting currency in their source rates, and base currency of cross rate is the base currency in its source rate.
In this scenario, the following is the rule:

Same sides and multiply with bids of source rates becoming the bid of cross rate; and offer of source rates becoming the offer of cross rate.
Let's understand this through the help of an example. Let's assume that we are required to find EUR/INR, the underlying rates are:
EUR/USD = 1.5775 / 1.5779
USD/INR = 40.3150 / 40.3200
The way to calculate this quickly, is to arrange the quotes in the following manner and use the cross rate arithmetic.

Traders Quick Method - 3

In our example, we can arrange our rates in the following manner.

Currency Pairs Bid Rate Ask Rate
EUR/USD 1.5775 1.5779
USD/INR 40.3150 40.3200
Therefore: \[ EUR/INR \text { (Bid) } = {1.5775 \text { x } 40.3150} = 63.5969 \] \[ EUR/INR \text { (Offer) } = {1.5779 \text { x } 40.3200} = 63.6209 \]

3 (b) One of the currency in the cross rate is base currency and the other is quoting currency in their source rates, and base currency of cross rate is the quoting currency in its source rate.
In this scenario, the following is the rule:

Same sides and multiply but take the reciprocal of derived rate and reverse the bid-offer sides for the cross rate.
Let's understand this through the help of an example. Let's assume that we are required to find INR/EUR, the underlying rates are:
EUR/USD = 1.5775 / 1.5779
USD/INR = 40.3150 / 40.3200
The way to calculate this quickly, is to arrange the quotes in the following manner and use the cross rate arithmetic.

Traders Quick Method - 4

In our example, we can arrange our rates in the following manner.

Currency Pairs Bid Rate Ask Rate
EUR/USD 1.5775 1.5779
USD/INR 40.3150 40.3200
Therefore: \[ EUR/INR \text { (Bid) } = {1 \over {1.5779 \text { x } 40.3200} } = 0.015718 \] \[ EUR/INR \text { (Offer) } = {1 \over {1.5775 \text { x } 40.3150} } = 0.015724 \]

FX Settlement

What is called as "Settlement Date" in other markets is called as "Value Date" in FX market. There are two dates in any trade - trade date and settlement date (value date). On trade date, the parties negotiate and finalise the trade; on Settlement (value date), the parties do the settlement (exchange the currencies, in case of FX).

FX Settlement - Value Date

The value date is after the trade date by a few days because the trade requires some processign work such as confirmation, netting, etc. The gap between the trade and value date can be either 1 or 2 business days.

FX settlement involves the exchange of the two currencies in the currency pair and is exposed to settlement risk. Settlement risk is the possibility that one party to the trade honours his obligations while the other does not. The following paragraphs discuss this aspect in detail.

Forex Settlement Risk
The unique feature of the forex settlement is that it takes place at two different settlement centers that are often located in different time-zones. For example, USD/JPY transaction is settled in Tokyo (for Yen amount) and New York (for Dollar amount), and the two centers are 13 hours apart in time zone. As a result, both would be not able to make the payment simultaneously, as while one center is working the other is not working. If the party making payment in Japanese Yen makes the payment then it would have to wait for about 13 hours to receive the payment in Dollars. Anything can happen in these 13 hours: for example, the counterparty may be declared insolvent, banned from transfering funds by the regulators, experience a force majeure event, etc., all of these would mean that the one of the party may not receive the funds, or at least on time.

Because of the time zone differences, the PvP (Payment versus Payment) style of settlement is impossible in forex markets. The non-simultaneous settlement of the two payments in a forex trade enhances the settlement risk, leading in turn to credit risk, market risk, liquidity risk and systemic risk. These risks are explained as below.

Settlement Risk:
It is the risk that one of the party would not honour his commitment on the settlement day. In the above example, the Yen payer has made the payment but his counterparty did not make the corresponding Dollar payments to him on the settlement date. This would be called as Settlement risk.

Credit Risk
In the above example, the Yen payer has not received his dollars. However, he has already transferred his Yen to the counterparty. Now, he needs to recover his Yen back from the counterparty, this would be termed as Credit risk, as there is obligation only from one party to the other.

Market Risk
In the above example, the Yen Payer's counterparty has defaulted on the trade. He now will have to replace that trade with a new trade, most probably with another counterparty. However, by now, the forex rate might have moved against him. This is called as Market Risk.

Liquidity Risk
In the above example, for the settlement of the new trade that the Yen Payer has undertaken, he needs to make payment again in Yen to receive Dollars. He may not have sufficient Yen anymore with him now as his original Yen is already blocked in his first failed trade. He may have to borrow Yen from the market to settle the second trade. However, the market may not be willing to give him money or the interest rates might be high. This risk is called as Liquidity Risk.

Systemic Risk
In the above example, it is quite possibe that due to the failure of the counterparty, the Yen Payer would suffer a credit risk and thereby fail in his obligation to another counterparty, who in turn may fail in his obligation to someone else. There can be a domino effect of these failures, which is called as Systemic risk.

The above stated risks are not hypothetical; they are real and are called as Herstatt Risk or Cross Currency Settlement Risk. The following case study explains this real risk that the FX market faces.

Bankhaus Herstatt

Bankaus Herstatt was a Cologne-based German bank, small in size but active in FX trading. Sharp increase in oil prices in 1974 led to weaker US dollar (USD), and Bankhaus Herstatt sold USD against Deustchemark (DEM) in speculative trades. In the settlement of USD/DEM transctions, Bankhaus Herstatt would receive DEM in Frankfurt and pay USD in New York.

German regulators discovered fraud and concealment of large trading losses by Bankhaus Herstatt. On June 26, 1974, the German authorities closed down Bankhaus Herstatt after the close of the interbank payments in Frankfurt. The time was 3:30pm in Frankfurt and 10:30am in New York. On receipt of this news, Herstatt's dollar correspondent banks withheld the payments to be made on behalf of Herstatt Bank.

As a result, Herstatt's counterparties lost their entire USD amount to be received in New York (credit risk), had to arrange for emergency funding to make good the loss of dollar amount from Herstatt (liquidty risk); and had to replace the original transaction with a new transaction at the prevailing market price (market risk). At least 12 counterparties faced these risks for a total amount of USD 200 million. To make matters worse, the other banks suspended payments and credit lines to the affected counterparties of Bankhaus Herstatt, unless they received confirmation that the counter-payment had already been received, leading to a gridlock in the payment system (systemic risk).

It was the first time that the market participants and the regulators realized the elevated risk in FX settlements.

Value Dates
The value dates in forex settlement can be grouped into three: spot, short and forward. Spot date is commonly defined as the second business day from the trade date. Any value date after the spot date (i.e. more than 2 business days) is called as forward date, and any value date before the spot date is called as short date. The below diagram shows these value dates.

Value Dates in FX

Spot Value Date
The spot value date, as discussed above, is two business days from the trade date. However, it is not always so. The following is the procedure to determine the spot value date.

Case A: USD is one of the currencies in the currency pair
Case B: USD is not one of the currencies in the currency pair (i.e. cross rate)
Because of the above adjustments, the spot value date may fall on third, fourth or even later after the trade date. The following algorithm shows the logic of calculating the spot value date.

Algorithm for Spot Value Dates

Forward Value Dates
Any value date after spot date is forward value date. Such dates are infinite but are quoted upto one year for most currency pairs. For hedging exposures beyond one year the market practice is to use derivatives such as currency swaps, currency futures and currency options, rather than currency forwards. The standard tenors in the forward value dates are 1W, 1M, 2M, 3M, 4M, 5M, 6M, 7M, 8M, 9M, 10M, 11M and 1Y, where W = week, M = month and Y = year.

The non-standard tenors are durations such as 45 days, 95 days, etc. They are called "Broken Dates" or "Odd Dates". The prices for broken dates are derived by interpolation from the prices of two nearest standard tenors. The following example illustrates this.

Consider that the following are the quotes in the currency pair USD/INR: You are required to find the forward rate for 45 days.

As per normal practice and also as prescribed by ISDA (International Swaps and Derivatives Association) in its 2006 Interest Rates Definitions, linear interpolation should be used to find the rate for broken period. The following diagram and calculations show this aspect.

Linear Interpolation

\[ {{x - 72} \over {45 - 30}} = {{74 - 72} \over {60 - 30}} \] \[ \text { or } {x = 73} \]

The standard tenors are relative to spot value dates, and not trade dates. For example, 1 month forward date is 1 month from the spot value date.

Short Value Dates
Short value dates are value dates before the spot value dates. There are only two such possible dates - trade date (T+0) and the first business day after trade date (T+1). Settlement on trade date is called as "Cash" value date and settlement on one business day after trade date is called as "Tom" value date, which is in short in tomorrow.

Sometimes cash value dates may not be possible because of time zone differences. For example, USD/JPY trade for cash value date is possible only during Tokyo trading hours, but not in New York trading hours, because when New York is open, Tokyo is already closed.

Tom value dates may not be possible sometimes due to holidays in one of the settlement centers. For example, Let's suppose CHF/JPY trade is contracted on January 27. Assume that January 28 and January 29 are business days at Zurich, Tokyo and New York. The spot value date would be January 29 and Tom value date would be January 28. However, if New York is closed on January 28, then Tom value date is not possible for this currency pair, because the next business day is the spot value date.

Which is the most important value date in forex?
As discussed above, spot value dates may not be possible in some currencies due to time zone differences. Tom value dates may not be possible in some currencies due to holidays in settlement centers. Sometimes forward value dates may not be possible due to exchange controls. Thus, the Spot value date is the most important value date in FX.

FX Deals

Forex deals can be classified into two types - Outright and FX swaps.

An outright transaction involves buying and selling a currency. Since forex trade is an exchange of two currencies, it is simultaneous buying of one currency and selling another currency.

For example:
In example 1 above, one of the party is buying EUR 1 million by selling USD. In example 2 above, one of the party is selling JPY 100 by buying USD.

Thus, the outright trades involves a bought currency and sold currency. The amount of one of them and the price is specified. The amount of the other currency is derived by "crossing" the deal amount with the price.

Forex Swap
There are two swaps with similar names: Forex swap and Currency swap. Until 1980, Forex swap was simply called "Swap". In the early 1980's, another swap was invented - Currency swap. Due to this, the traditional swap is now called as Forex swap and the new swap is called as Currency swap.

Not all swaps are derivatives. Forex swap and Bond swap are called swaps but they are not derivatives. Forex swap is a financing tool (we will discuss about this in the following paragraphs), and Bond swap is a barter or swap of two bonds and not a derivative.

Forex swap consists of simultaneous buying and selling of the same currency on the same currency pair for the same amount but for different value dates.

Consider the following example:
The above two are not independent trades but two legs of the same trade. The leg that settles first is called the near leg and the other leg is called the far leg. We distinguish two kinds of forex swaps: buy-sell (B-S) and sell-buy (S-B) swaps. The market side of the near leg is always written first. Thus, in a B-S swap, the market side of the near leg is buy and that of the far leg is sell; and the converse for the S-B swap. Notice that both the legs have the following features:
The only trade parameter that is not specified is the price for the two legs. The price is market-driven.

To understand the forex swap better, let's look at the following diagram.

Cash flows of a FX swap

In the above diagram, let's ignore the USD cash flows for a moment. If we focus only on the EUR cash flows, we can think that Party A has borrowed EUR from Party B on the near date @ price 1 and returned the same back to Party B on the far date @ price 2. If we analyse in this way, it looks like a financing or borrowing trasactions - i.e. a borrow-lend transaction rather than buy-sell transaction.

Now, let's ignore the EUR cash flows for a moment. If we focus only on the USD cash flows, we can think that Party B has borrowed USD from Party A on the near date @ price 1 and returned the same back to Party A on the far date @ price 2.

Now, let's consider both EUR and USD cash flows and think like this.............. that Party A has borrowed EUR from Party B by giving USD as a collateral on the near date @ price 1 and on the far date returned the borrowed EUR to Party B and collected back the USD collateral that it had posted @ price 2. In this way, from the point of view of Party A, this looks like a secured borrowing transaction in EUR whereby USD is acting as a collateral.

Alternatively, we can also think about this like this.............. that Party B has borrowed USD from Party A by giving EUR as a collateral on the near date @ price 1 and on the far date returned the borrowed USD to Party A and collected back the EUR collateral that it had posted @ price 2. In this way, from the point of view of Party B, this looks like a secured borrowing transaction in USD whereby EUR is acting as a collateral.

Forex swap is thus a combination of borrowing and lending in two different currencies of equivalent amount. In otherwords, forex swap is the simultaneous borrowing and lending of two currencies between two parties on different dates for the same amount but for different price. The two money trades are combined into a single package called forex swap. The currency lent is secured by the currency borrowed and vice-versa. Forex swap is similar to repo trades in money markets. Whereas repo is borrowing of money against a collateral of a financial security, forex swap is borrowing of one brand of currency against the collateral of another brand of currency.

The question now is What constitute price 1 and price 2 in the forex swap?

On the near date, the rate of exchange between the currencies is linked to the prevailing market price. On the far date, the same amounts of currencies are re-exchanged along with the two interest amounts. The two interest amounts are converted into quoted currency and clubbed with the principal amount to derive the price for the far leg.

In the above example, let's assume that the price 1 (spot price on the near date) is USD 1.11994. Let's further assume that following: Euro interest rate = 2% p.a., US Dollar interest rate = 3%, The far date is 1 year from the near date, and the amount borrowed by Party A is EUR 1.

As explained above, FX swap is a borrow-lend transaction. Party A has borrowed EUR @ 2% for a period of one year. The interest that it needs to pay on its borrowing is EUR 0.02. The total amount that needs to be refunded by Party A to Party B on the far date is 1.02 (Principal of EUR 1 plus interest of EUR 0.02).

Similarly, Party B has borrowed USD 1.11994 (as per the spot exchange rate) from Party B. Interest @ 3% is applicable on this borrowing; the interest due would be USD 0.03359. The total amount that needs to be refunded by Party B to Party A on the far date is USD 1.15353.

On the far date, the parties will have to exchange back their currencies. The exchange rate applicable (price 2) can be computed by using the total amount that needs to be exchange. In our example, EUR 1.02 is exchange against 1.15353. Thus, the exchange rate (price 2) would be 1.13091 (EUR/USD = 1.13091).

To summarise, the following are the characteristics of FX swap.

Interbank Rates and Arbitraging

Arbitrage refers to simultaneous purchase and sale of the same or different assets with a view to earn risless profit. Financial markets, including currency markets, are efficient and the possibility of earning arbitrage profit rarely exists. However, imperfections may creep into these markets giving rise to arbitraging possibilities. The following paragraphs discuss these possibilities.

Let's consider the following two quotes by two dealers in the market on the currency pair USD/INR
We are the price takers in this example and we are scouting for the best rate from different banks. Assume that we want to buy USD. The USD rate is costlier with UBS than Barclays; yet the rates are such that arbitraging is not possible. Let's say that we want to buy USD from Barclays and sell it to UBS. We can buy USD 1 @ INR 70.6300 from Barclays but our selling rate to UBS would be INR 70.6250, which is less than our buying price. We will incur a loss of INR 0.005 on our transaction. As long as the rates quoted by the market markers overlap, there is no arbitraging possibility.

Arbitraging profits can arise if the rate quoted by one market maker falls outside the range of the other. Suppose the following rates are prevalent: In this case, we can buy USD from Barclays at INR 70.6225 and sell it to UBS at INR 70.6250, thereby making a profit of INR 0.0025 per dollar. But continued operations by arbitrageurs in the market will put pressure on Barclays and will force it to raise its dollar quote. On the contrary, the buying pressure of USD on UBS will make them to alter their rates too, eliminating the arbitraging chances over time.

Why should the rates quoted by market makers differ? Initially, it may be trial and error effor to reach the equillibrium rate. It could also be deliberate attempt by the market maker, either to buy or sell the currency depending upon his exchange position in the currency concerned. A market maker is expected to buy or sell the currency as required by the counterparty irrespective of his own position in the currency. As a result a bank (or market maker) which has over bought in one currency may end-up with transactions which further add to this balance. A market maker cannot explicitly say whether he prefers to buy or sell the currency. However, he may quote the rate in such a way that he ends up with desired type of transactions.

Forward Exchange

Forward exchange is the link between the spot forex market and the money market for two currencies. Money has time-value, which is called "rent" or "interest on money". Forex transaction has two brands of money and their interest rates jointly determine the time-value of forex price. This is the basis of forward exchange. The following example illustrates this aspect.

Let's assume that EUR/USD spot price is 1.5000
Interest rate for EUR is 3%
Interest rate for USD is 2%
If EUR and USD were to be exchanged after one year (instead of on the spot value date) then what should be the rate of exchange?

If EUR 1 were to be invested for 1 year @ 3%, it would become 1.03 at the end of 1 year
If USD 1.5 were to be invested for 1 year @ 2%, it would become 1.53 at the end of 1 year
1.03 EUR = 1.53 USD; or
1 EUR = 1.53/1.03 = 1.4854 USD

The two interest rates together with the spot price determine the forward exchange rate. This is called "Covered Interest Parity (CIP)" or "Interest Rate Parity (IRP)". If in the above example, the forward price is other than 1.4854 (say 1.4900), EUR is overpriced in the forward and can be arbitraged for risk-free profit by executing the following trades simulataneously.

Swap Points
The difference between the spot and forward price is called "Forward Differential" or "Swap Differential" or "Swap Points".

Swap Point = Forward Price - Spot price

If the forward price is higher than the spot price then the swap points will be positive.
If the forward price is lower than the spot price the the swap points will be negative.
If teh forward price is lower than the spot price the swap points will be at zero.

In commodities market, when the forward prices are more than the spot prices, the market is said to be in "contango". If the forward prices are less than the spot prices, the market is said to be in "backwadation". And if the forward prices and spot prices are the same, the market is said to be "at par".

The "premium" and "discount" are used with respect to base currency and they relate to the spot price. Consider the following currency pairs:

Currency Pair Spot Price Forward Price Remark
EUR/USD 1.5000 1.48543689 EUR is at a discount
USD/EUR 0.66666667 0.67320262 USD is at a premium

In forward exchange arithmetic, two following two importants points need to be kept in mind.
However, the three are equal only approximately. The following table illustrates this case, using the currency rates depicted in the above table.

Premium / Discount Difference calculation Difference amount in %
Discount on EUR (1.48543689 - 1.5000) / 1.5000 -0.97087379%
Premium on USD (0.067320262 - 0.6667) / 0.6667 +0.98039216%
Difference in interest rates 3% - 2% +1%

As you can see, all the three don't match exactly; they match only approximately. The reason is because we are using wrong method for our calculations. The difference between premium (%) and discount (%) is similiar to that of the difference between yield and discount in interest rate arithmetic. Yield has the interest paid in arrears (ex post), but discount has the interest paid in advance )ex ante. For correct comparision, we should use the following method.
The following tables shows this re-calculation.

Premium/Discount Difference calculation Difference amount in %
Discount on EUR (1.48543689 - 1.5000) / 1.5000 -0.97087%
Premium on USD (0.67320262 - 0.66666667) / 0.67320262 + 0.97087%
Difference in interest rates (1.02 / 1.03) - 1 - 0.97087%

In general, for comparison in arbitrage calculations, when the deal currency is base currency, compute the premium/discount as a percentage of spot price; and when it quoting currency, compute the premium/discount as a percentage of forward price.

Forward Exchange Arithmetic with two-way quotes
As discussed earlier, a single way quote has only illustrative value but no practical value. In the FX market, participants provide two-way quote even for forward prices. Thus, it is important for us to understand the arithmetic involved in it.

Consider the following quote: Notice that in the above quote, the two annual interest rates are given which are different for the bid and ask prices.

Our objective is to derive the two-way one-year forward price of EUR/USD. Let's represent the bid as "x" and offer as "y". Thus, our quote is in the form of x/y, where x is the price marker's (quoter's) buying price and y is the price maker's selling price. As explained in the section on "Cross Rate Arithmetic with Two-Way Quotes", the derivation of any price is based on hedge. You buy on the quote and sell it immediately in the market. In other words, when you quote a price to someone, your buying price and selling price for a currency are the market's buying and selling prices, respectively, too.

The following illustrates the concept to compute the forward rate. Let us assume that we are the price marker in this example.

Bid Price Offer Price
We show the current spot bid price to the price taker. The spot bid price is 1.4998. We show the current spot offer price to the price taker. The spot offer price is 1.5002.
The price taker wants to sell EUR after 1 year. That means we will be stuck with our dollars for an year. The total amount of dollars that we have is 1.4998. We can lend these dollars in the market for an year instead of keeping them with us. We can lend the dollars in the market at the market's borrowing rate. In the quotes given above, the market's dollar borrowing rate is 1.96875% (the market would want to borrow at a cheaper rate and lend at a higher rate). After 1 year, our 1.4998 will become 1.5293273. The price taker wants to buy EUR after 1 year. That means we will be stuck with our Euros for an year. The total amount of Euros that we have is 1. We can lend our Euros in the market for an year instead of keeping it idle. We can lend the Euros in the market at the market's borrowing rate of 2.96875% (the market would want to borrow at a cheaper rate and lend at a higher rate). After 1 year, our EUR 1 will become EUR 1.0296875.
In the meanwhile, we need our Euros (EUR 1). We can borrow EUR from the market at the market's lending rate i.e. 3.03125%. If we borrow EUR 1 for an year, we will have to repay EUR 1.0303125 after an year. In the meanwhile, we need Dollars (USD 1.5002). We can borrow USD from the market at the market's lending rate i.e. 2.03125%. If we borrow USD 1.5002, we will have to repay USD 1.5306728 after an year.
We can now compare the value of the two currencies after one year i.e. USD 1.5293273 and EUR 1.0303125. These are the future values of the two currencies one year from now. From this, we can derive the forward bid rate for EUR/USD, which will be 1.4843334. We can now compare the values of the two currencies after one year, i.e. USD 1.5306728 and EUR 1.0296875. These are the future values of the two currencies one year from now. From this, we can derive the forward ask (offer) rate for EUR/USD, which is 1.4865411

EUR/USD 1 Year Forward Rate: 1.4843334 / 1.4865411.

The above is an explanation of the concept behind deriving the forward exchange rates. For quick calculation, we can use the cross rate arithmetic method. The following diagram depicts the method, the calculation follows.

Forward Exchange Cross Rates

\[ Forward_{bid} = Spot_{bid} \text { x } [{{1 + QC_{bid}} \over {1 + BC_{offer}}}] \qquad \qquad { and } \qquad \qquad Forward_{offer} = Spot_{offer} \text { x } [{{1 + QC_{offer}} \over {1 + BC_{bid}}}] \] \[ \text {where QC_bid = Quoting currency bid rate;} \\ \text {QC_offer = Quoting currency offer rate;} \\ \text {BC_bid = Base currency bid rate;} \\ \text {BC_offer = Base currency offer rate} \\ \] \[ Forward_{bid} = 1.4998 \text { x } [ { {1 + 1.96875 \text {%} } \over {1 + 3.03125 \text {%} } } ] \qquad \qquad { and } \qquad \qquad Forward_{offer} = 1.5002 \text { x } [ { {1 + 2.03125 \text {%} } \over {1 + 2.96875 \text {%} } } ] \] \[ Forward_{bid} = 1.48433 \qquad \qquad \text { and } \qquad \qquad Forward_{offer} = 1.48654 \]

Nature of Swap Points
Spot forex price is the price of an asset and can never be zero or negative. Interest rate is the time-value of money and is always positive and can never be negative.

In the recent times, we have witnessed negative interest rates in CHF and JPY. However, those rates are not used for forex price calculation purposes.
Swap points are neither the price of the asset or the time value of money and hence they can be positive, negative or zero.

The derivation of swap points consists of the following steps for each of the currencies:
In general, both sides of the two-way swap quote will have the same sign (e.g. 0.0010 / + 0.0012 or -0.0012 / -0.0010). The sign indicates whether the swap points are to be added or subtracted. If the sign is positive then we should add it to the spot price. If the sign is negative, we should substract it from the spot price. If the interest rates are the same for both the currencies, the swap points will be zero. However, transaction costs and bid-offer spreads will make the swap points deviate from zero on either side.

Swap Points Conventions
As discussed earlier, swap point is the difference between forward price and spot price. There are three market conventions on quotes on foreign exchange. They following are they:
  1. Quote forex price only for spot price
  2. Swap points are quoted as whole numbers
  3. Sign of the two-way quote is dropped for same signs
Quote forex price only for spot price
As per this convention, the following is how the prices are quoted.

Quote Terms Rate (Price)
Spot 1.5000 / 10
1 Month + 0.0010 / + 0.0011
3 Month + 0.0025 / + 0.0027
6 Month + 0.0049 / + 0.0053

In the above quote, the forward prices can be derived by adding or substracting the swap points from the spot price.
If the swap points are ascending then we must add them to the spot price.
If the swap points are descending then we must deduct them from the spot price

Swap points are quoted as whole numbers
As per this convention, the following is how the prices are quoted.

Spot Price Swap (Quote) Divisor Swap Value
0.5775 10.5 104 0.00105
1.2575 10 104 0.0010
12.375 10 103 0.010
37.75 10 102 0.10
110 10 100 10

Sign of the two-way quote is dropped for same signs
As per this convention, the following is how the prices are quoted.

Swap point quote Description Quoted in the market as
+10 / +10 is quoted as 10 / 11
- 11 / -10 is quoted as 11 / 10
-11 / + 10 is quoted as -11 / +10

Notice that when the swap points are positive on both sides, the swap quote is in ascending order. When the swap points are negative on both sides, the quote is in descending order.

Commercial Transactions

Forex trades are accounted in two books: (1) Proprietary trading book; and (2) Commercial book.

Proprietary Trading Book
In this book, the bank maintains a position in the market, which results in profit or loss. For these transactions, the bank does not need a customer, it deals with another dealer in the market.

Commercial Transactions Book
These are those transactions that are initiated with customers. The bank is not exposed to market risk; the market risk is borne by the customer. The bank earns a margin or spread or both. The commercial transactions can be further divided into two types as follows
Currently, much of the business is commercial transactions (either flow trading or commercial). The volume of proprietary trading has reduced drastically after the financial crisis of 2008 and the implementation of restrictions on proprietary trading under Dodd-Frank Act of U.S.

Commercial Transactions
In the commercial transactions, one of the party is a bank or dealer while the other is a commercial customer. The following can be the commercial customers.
Commercial transactions are predominantly outright trades. The transaction size is relatively small and, possibly, for odd dates, suiting their underlying business or personal requirements. Forex swaps are not allowed in most countries, they are restricted to the inter-dealer market. One of the currency in the commercial transactions is always the local currency, while the other could be any foreign currency.

Classification of Commercial Transactions
All commercial transactions (outright) are classified into two types (1) Purchase; and (2) Sale. The purchase and sale, here, is in reference to the bank and foreign currency. When we say "purchase", it means the bank purchases the foreign currency from the customer against the local currency. When we say "sale", it means the bank sells the foreign currency against the local currency.

Purchase and Sale transactions can be further classified into the following two types:
Clean Transactions
Clean transactions are those that do not require handling of trade documents. The customer and bank simply exchange currencies, with little or no paper work. The following are some examples of clean transactions:
Most of the above type of transactions are commonly referred to as "remittances".

Bill Transactions
Bill transactions are related to exports and imports and involve handling of trade documents such as Bill of Lading, Invoices, etc., by the bank. Bill transactions may be under Letter of Credit (L/C) or outside it.

Margin Price or Margin
The prices for commercial transactions are quoted based on hedge or cover in the market. If a bank buys foreign currency from the customer, it sells it in the market immediately.

Exchange Rate for Commercial Transactions
Exchange quotation between a bank and its customer is not a two-way quotation. The customer has to obtain a rate specifically providing all the details of the transaction. Therefore, merchant rate (or commercial rate) is a one-way quotation and applicable for a specific transaction only.

Basis for Commercial (Merchant) Transactions
When the bank buys foreign exchange from the customer, it expects to sell the same in the interbank market at a better rate and thus make a profit out of the deal. In the interbank market the bank will accept the rate dictated by the market. It can therefore sell foreign exchange in the market at the market buying rate for the currency concerned. Thus, the interbank buying rate forms the basis for quotation of buying rate by the bank to its customer.

Simillarly, when a bank sells foreign currency to the customer, it meets the commitment by purchasing the required foreign exchange from the interbank market. It can acquire the foreign exchange from the market at the market's selling rate. Therefore, the interbank selling rate forms the basis for quotation of selling rate to the customer.

The interbank rate on the basis of which the bank quotes its merchant price is known as "basis rate".

Exchange Margin
If the bank quotes the base rate to the customer, it makes no profit. On the other hand, there are administrative costs involved. Further, the deal with the customer takes place first. Only after acquiring/selling the foreign exchange from/to the customer, the bank goes to the interbank market to sell or acquire the foreign currency required to cover the deal with the customer. Some time (maybe 2 hours or so) may have elapsed by this time. The exchange rates are fluctuating constantly and by the time the bank concludes the cover deal in the market, the exchange rate might have turned adversely to the bank. Therefore, sufficient margin should be built into the rate to cover the administrative costs, exchange fluctuations and also to provide some profit to the bank. This is done by loading exchange margin to the base rate. The quantum of margin depends from bank to bank and also on the market trend.

Indian Scenario:
Upto 1995, the exchange margin were prescribed by FEDAI. The following were the margins:-

Finess of Quotation
The exchange rate is quoted upto 4 decimals in multiples of 0.0025. The quotation is for one unit of foreign currency except for the following currencies, where the quotation is for 100 units of the foreign currency.
Usually, the calculations can be made upto 5 decimal places and rounded up to 4 decimal places. For example, if US dollar is INR 69.12446, it can be rounded off to 69.12450.

Types of Buying Rates
Depending on the time of realisation of foreign exchange by the bank, the buying rate can be classified into 2 types as follows:

TT Buying Rate
TT stands for "Telegraphic Transfers". This is the rate applied when the transaction does not involve any delay in realisation of the foreign exchange by the bank. In other words, the nostro account of the bank would already have credited.

Though the name implies telegraphic transfers, it is not necessary that the proceeds of the transaction are received by telegram. Any transaction where no delay is involved in the bank acquiring foreign exchange will be done at the TT rate. Examples of TT rate transactions are payment of demand drafts, mail transfers, telegraphic transfers, etc., drawn on the bank where bank's nostro account is already credited., foreign bills collections, etc.

Calculation of TT Buying Rate
The method of calculation of TT buying rate is as follows:

Spot buying rate : abcd
Less: Exchange margin : pqrs
TT buying Rate : (abcd-pqrs)

Example - 6
The spot rate of USD/INR is 70.1296. Calculate the TT buying rate if the exchange margin is 0.08%?

USD/INR spot rate = 70.1296
Less: Exchange margin @ 0.08% = 0.05610 TT buying rate = 70.0735

Bill Buying Rate
There are two types of bills, in general - Sight bill and Usance bill. A sight bill is paid as and when it is presented. A usuance bill is paid only on the due date.

This rate is applicable when a foreign bill is purchased. When a sight bill is purchased, the local currency equivalent of the bill value is paid to the customer (usually exporter) immediately. However, the proceeds of the foreign bill is realised by the bank after a certain delay - the bill needs to be presented to the drawee at the overseas center. In the case of usance bill, the bill will be paid only on the due date. So, till that time, the bank does not get its money.

If a sight bill is purchased, the realisation will be usually after 25 days (transit period). The bank would be able to dispose of the foreign exchange in the inter-bank market after this period. Therefore, the rate quoted to the customer would be based on the 25-day forward rate, instead of the spot rate. Simillarly, in case of an usuance bill, the bill may be realised after about 55 days (25 days transit period plus 30 days usuance period). Therefore, the bank would quote a 55-day forward rate to the customer, instead of the spot rate.

The forward rates are available for standard periods or monthly durations upto 1 year. Forward rates are not readily available for broken periods such as 25-days or 55-days. In an earlier section on Forward Exchange Rates, we had discussed about how to compute the forward rates for broken dates using linear interpolation. The bank can either use the linear interpolation method or offer the cheaper standard monthly rate to the customer. For example, consider the following rates:-
In the above example, there is no 25-day rate. The nearest rates are for spot and 30-days rate. The bank can use these two nearest rates to find out the 25-days rate. Alternatively, the bank can use the rate that is beneficial to it. The forward rates are at a premium. The 30-days rate is expensive than the spot rate. Therefore, the bank can offer the spot rate to the customer i.e. 69.5000.

Note: If the forward swap points are positive (ascending order), we add them to the spot price. If the forward swap points are negative (descending order), we deduct them from the spot price.

Calculation of Bill Buying Rate
The method of calculating bill buying rate is as follows:-

Spot buying rate : abcd
Add: Forward premium : efgh
Less: Forward discount: ijkl
Less: Exchange margin: pqrs
Bill buying rate: (abcd + efgh - prqs) OR (abcd - ijkl - pqrs)

Example - 7
On 25th July, a customer presents to the bank at sight documents for USD 100,000 under an irrevocable letter or credit. Assuming the rates are as under, calculate the bill buying rate?
Spot USD / INR = 69.6525 / 6650
Spot / August = 6000 / 5700
Spot / September = 1.000 / 0.9700
Spot / October = 1.4000 / 1.3900
Transit period is 25 days and exchange margin is 0.15%

The calculation is as follows:
Spot = 69.6525
Less: Discount (1 month) = 0.6000
1-month forward rate = 69.0525
Less: Exchange margin @ 0.15% = 0.10357
Bill buying rate = 68.9489

Types of Selling Rates
When a bank sells foreign exchange it receives the local currency from the customer. The sale is effected by issuing a payment instruction to the corresponding bank to debit its nostro account. As discussed earlier, a bank operates by covering or hedging its position. Therefore, immediately upon sale, the bank buys the requisite foreign exchange from the market and gets its nostro account credited with the amount. If the bank already maintains some inventory of foreign exchange then the payment to the client can be done easily. Otherwise, the bank must first receive the foreign currency that it bought into its nostro account so that the payment instructions to the customer can be cleared.

Therefore, for all sales to the customers, the bank resorts to the interbank market immediately for purchasing. Depending on whether the sale involves handling of documents or not, there are tow types of selling rates, as mentioned below.
TT Selling Rate
This rate is used for all transactions that do not involve handling of documents by the bank. Generally, this rate is used for issuance of demand drafts, mail transfers, telegraphic transfers, etc., and cancellation of foreign exchange purchased earlier.

Calculation of TT Selling Rate
This rate is calculated on the basis of the interbank selling rate. The rate to the customer is calculated by adding exchange margin to the interbank rate, as described below:-

Spot Rate : abcd
Add: Exchange margin: pqrs
TT selling rate = (abcd - pqrs)

Example - 8
The spot rate of USD/INR is 70.1296. Calculate the TT selling rate if the exchange margin is 0.08%?

Spot rate = 70.1296
Add: Exchange margin @ 0.08% = 0.05610
TT selling rate = 70.1857

Bill Selling Rate
This rate is used for all transactions which involve handling of documents by the bank such as payment against import bills. The bill selling rate is calculated by adding exchange margin to the TT selling rate. That means the exchange margin enters into the calculation twice, once on the inter-bank spot rate and again on the TT selling rate.

Calculation of Bill Selling Rate
The following is the method for calculation of bill selling rate.

Spot rate : abcd
Add: Exchange margin for T.T. : pqrs
TT selling rate: (abcd - pqrs)
Add: Exchange margin for bill : klmn (on TT selling rate)
Bill selling rate: (abcd + pqrs + klmn)

Example - 9
The spot rate of USD/INR is 70.1296. Calculate the bill selling rate if the TT selling echange margin is 0.08% and bill selling exchange margin is 0.1%?

Spot = 70.1296
Add: Exchange margin for TT @ 0.08% = 0.05610
Add: Exchange margin for Bill @ 0.01% = 0.0701857
Bill selling rate = 70.25588

General practices in quotes to customers
If the customer is a premium customer, then the bank may quote a better rate than normal customers. Similarly, in case of large value transactions, the bank may quote a better rate. For transactions where the value is less (for example say less than USD 1,000 or equivalent in other currencies), the bank may not calculate the rates for each transactions separately. Instead, it can offer the beginning of the day rate to all transactions for that day. These rates are called as "Card Rates".

Buying and Selling Rates based on Cross Rates
If the customers purchase or sell USD to the bank then the bank will need to simply base its calculation on the inter-bank numeraire rates. However, if the customer buys or sells any other currency other than USD then the bank must find the exchange rate by crossing the interbank numeraire rates, which is called Cross Rate. (We have discussed this topic in the cross rate section of this reading material). Let's understand this concept through the following example:-

Let's suppose that an exporter has received an advance remittance of Danish Kroner 100,000. He likes to retain 15% of it and sells the balance to the bank. Calculate the amount payable to the exporter if the following are the interbank market rates.

Spot USD\INR = 69.3500 / 3600
1M - Forward = 1100 / 1200
Spot USD\DKK = 6.9220 / 9280
1M - Forward = 40/45

In this example, the customer is selling DKK to the bank. The bank needs to pay him the local currency i.e. INR. To facilitate this transaction, the bank will try to quote an exchange rate based on the premise that it would immediately sell the DKK that it purchases from the customer in the interbank market. However, in the interbank market there is no direct exchange rate between DKK and INR. All currencies are quoted against USD. Thus, the bank first will have to find the cross rate between DKK and INR by using USD-DKK and USD-INR rates. One way to find the cross rate is by exchanging USD to INR. In this example, the bank would have to sell DKK (that it bought from the client) in the market. It can do so at the market's buying rate, which is USD 1 = DKK 6.9280. So, if the bank sells DKK 6.9280, it would get USD 1. It can then sell the USD on the USD/INR currency pair and buy INR. This can be done at the dollar buying rate, which is USD 1 = 69.3500. Thus, if we have DKK 6.9280 to start with, we can exchange and get INR 69.3500. The exchange rate between DKK/INR would be 10.0101.

Depending on the above, the rate quoted by the bank to the customer would be as follows.

DKK / INR spot rate = 10.0101
Less: Exchange margin @ 0.08% = 0.00800
Rate offered to the client = 10.0021

For DKK 85,000, the amount payable to the customer will be 85,000 x 10.0021 = 8,50,178.50/-

Administration of Foreign Exchange in India

For a long time, foreign exchange in India was treated as a controlled commodity because of its limited availability. The early stages of foreign exchange management in the country focussed on control of foreign exchange by regulating the demand due to its limited supply. Exchange control was introduced in India in 1939. In was followed by the Foreign Exchange Regulation Act of 1947 and 1973. Over the years, the exchange controls have been diluted substantially and reduced by exchange management. Currently, the Foreign Exchange Management Act, 1999 governs foreign exchange transactions of the country. The Reserve Bank of India is the principal regulator of this regulation.

Authorised Persons
The Reserve Bank of India has the authority to administer foreign exchange in India. Foreign exchange is required by a large number of people such as exporters, importers, investors, students, travellers, etc. It would be impossible for the RBI to deal with such a large number of participants individually. Therefore, provisions have been made in the Act enabling the RBI to authorise any person, to be known as "Authorised Person" to deal with foreign exchange.

Currently, there are two types of authorised persons, as follows.
Authorised Dealers
There are three categories of authorised dealers, as below.

Authorised Dealers - Category 1
The category 1 authorised dealers are banks. They are authorised to carry out all current account and capital account transactions as permitted by RBI from time to time. Any exporter or importer should route his transactions through Category 1 dealers only.

Authorised Dealers - Category 2
They comprise of upgrated full-fledged money changers, cooperative banks, regional rural banks and others. They can purchase and sell foreign exchange for private and business visits abroad undertaken by residents, remittances for education, medical expenses, subscriptions, etc.

Authorised Dealers - Cateory 3
They are selet financial or other institutions. They are permitted to carry out transactions incidental to the foreign exchange activities undertaken by them.

Authorised Money Changers
To provide facilities for encashment of foreign currency for tourists, etc., Reserve Bank of India has granted licences to certain established firms, hotels and other organisations permitting them to deal in foreign currency notes, coins and traveller's cheques subject to directions issued to them from time to time. These firms and organisations are called "Authorised Money Changers". An authorised money changers may be "full-fledged" money changer or a "restricted money changer".

A full-fledged money changer is authorised by RBI to undertake both purchase and sale transactions with public for private and business visits abroad. The department of posts, urban cooperative banks and other are recognised as full-fledged money changers.

A restricted money changer is authorised only to purchase notes, coins and travellers cheques, subject to the conditions that all such collections are surrendered by it, in turn, to the authorised dealer.

Some general questions pertain to foreign exchange in India for retail clients

How much foreign currency can be carried in cash for travel abroad?

For all countries except Iraq, Libya, Iran, Russia and other CIS countries
Maximum Cash = USD 3000 per visit
Cards, Cheques, etc. = Upto USD 2,47,000 per visit, if maximum cash limit is utilised. Else, upto the full limit of USD 2,50,000.

For Iraq and Libya
Maximum Cash = USD 5000 per visit
Cards, Cheques, etc. = Upto USD 2,45,000 per visit, if maximum cash is utilized. Else, upto the full limit of USD 2,50,000.

For Iran, Russia and other CIS countries
Cash = Upto USD 2,50,000
Cards, Cheques, etc. = Upto USD 2,50,000
(The maximum limit of foreign exchange is USD 2,50,000. Hence, if cash is taken then amount of card value has to be accordingly reduced.)

For Haj
Cash = Upto USD 2,50,000
Cards, Cheques, etc. = Upto USD 2,50,000
(The maximum limit of foreign exchange is USD 2,50,000. Hence, if cash is taken then amount of card value has to be accordingly reduced.)

Is there any limit as to how much foreign exchange you can bring back to India?

No limit. However, if the cash is more than USD 5,000 or if total foreign exchange is more than USD 10,000 then it must be declared to customs.

Is there any time frame for returning of foreign currency once one is back in India?

Yes. Usually, the money should be returned to a bank within 6 months time from the date of returning back to india. Tourists can retain upto USD 2,000 for personal or future travel purposes. They can also credit their resident Foreign Currency (Domestic) Account (RFC account).

Can a person resident in India hold assets outside India?

Yes. A person resident in India is free to hold, own, transfer or invest in foriegn currency, foreign security or any immovable property situated outisde India if such currency, security or property was acquired, held or owned by such persons when he was resident outside India or inherited from a person who was resident outside India. Further, a resident individual can also acquire property and other assets under LRS (Liberalised Remittance Scheme).

Foreign Currency Accounts

To facilitate dealings in foreign exchange, banks maintain accounts with other banks abroad. For instance, Barclays Bank of London may maintain a dollar account with Bank of America in New York. Similarly, Bank of America (U.S) may maintain a pound sterling account with Barclays in London, or any other bank in London. When the banks maintain accounts mutually with each other, there may arise confusion as to which account they are referring to in the correspondence. Banks use certain specific terms to identify the accounts to avoid the confusion.

Nostro Account
The term "Nostro" is used by a bank to refer to its account with another bank (usually a foreign bank). In the case above, Barclays London will refer to its dollar account with Bank of America New York as its nostro account. Simillarly, Bank of America New York will refer to its pound account with Barclays London as its nostro account. So, while corresponding with Bank of America, Barclays will refer to its dollar account with Bank of America as "my nostro account", which means "our account with you".

Vostro Account
The term "Vostro" is used by a bank to refer to the account maintained by a foreign bank with it. In the above case, Barclays London will refer to the pound sterling account maintained by Bank of America with it as "Vostro account". Vostro here means "your account with us. Similarly, Bank of America will refer to the dollar account maintained by Barclays London with it as "Vostro account", in its correspondence with Barclays.

Loro Account
The term "Loro" is used when the account is referred by a bank other than the account maintaining bank and the bank with which the account is maintained. In the above case, Citi Bank London can refer to the pound account of Bank of America New York maintained with Barclays London as "Loro account". Loro means "their account with you".

Continuous Linked Settlement (CLS)

Continuous Linked Settlement (CLS) is an international payment system which was launched in September 2002 for the settlement of foreign exchange transactions. In the conventional settlement of foreign exchange transactions the exchange of two currencies involved in the trade is not normally synchronous. For one party to the trade there is therefore a risk that it will transfer the currency it has sold without receiving from the counterparty the currency it has bought (settlement risk). Even if the bank's risk position vis-a-vis a counterparty is short-term, it may be many times greater than its capital. With CLS, an infrastructure has been created which eliminates settlement risk by means of a payment versus payment (PvP) mechanism.

Risks in the settlement of foreign exchange transactions
If there is no direct account relationship between two operators on the foreign exchange market, foreign exchange transactions are traditionally settled via corresponding banks. The following picture depicts this method of settlement.

In this kind of a settlement when one party meets its obligation irrevocably, it does so without knowing whether its counterparty will settle its liability. This means that there is a risk of the counterparty delivering late (liquidity risk) or, in the worst case, not at all (credit risk). These risks are compounded in the foreign exchange market if the market participants are in different time zones. If one party does not fulfill its obligations, depending on the size of the transaction liquidity and/or solvency, problems may arise for the counterparty and thereby trigger a chain reaction (systemic risk).

The Herstatt Risk (described in an earlier section) brought foreign exchange trading settlement risk to the notice of the general public for the first time. As the foreign exchange market grew steadily in size over the years following, central banks realised the degree of potential systemic risk and called upon the banking sector to design a risk-reducing multi-currency settlement system. This led to the establishment of CLS in 2002.

Main features of the CLS system
In principle, foreign exchange transactions are - apart from the exchange rate risk - self collateralising transactions. A liability in one currency is always covered by a claim in another currency. However, the self-collateralisation functions only if both parties can also be guaranteed to meet their liabilities. In simplified terms, in a foreign exchange transaction CLS is interposed between the two trading parties in order to coordinate the mutual liabilities created by a foreign exchange transaction. CLS ensures that the flow of funds are transferred simultaneously between the parties involved by means of the PvP mechanism so as to eliminate settlement risk for the two parties. All these needs to be done by keeing in view the liquidity and security requirements. This aspect is explained in the following paragraphs.

Separation of settlement and funding
In principle, PvP settlement of a foreign exchange transaction via CLS could be carried out extremely easily: the two parties to the trade pay the currencies they have sold to CLS. CLS, then, settles the two sides of the foreign exchange transactions simultaneously and pays out the currencies to the participants that they have bought. If one the party does not pay its liability to CLS then the settlement is not done. Note that CLS is not a CCP (Central Clearing Counterparty). It is only providing administrative support to ensure that settlement occurs. The settlement of one leg of the transaction is linked (or dependent) on the settlement of the other leg. Parties may carry out numerous foreign exchange transactions in a day. In some of the transactions they may act as buyers, while in others they may act as sellers. If they were to transfer the amounts individually then it would be very expensive for them. Since with this extreme secure mechanism the flow of funds of each transactions settled also has to be transferred individually, the participants would have to provide large amounts of expensive liquidity.

In order to reduce participants' liquidity requirements, the settlement of instructions has therefore been separated from the resultant payment flows. This enables the instructions to be settled individually on a gross basis (gross settlement), while at the same time the resultant payment obligations are netted. As a consequence only the balance of the netted claims and liabilities i.e. participants respective net positions are transferred via the system (net funding). Participants liquidity requirements can be significantly reduced in this way. Because of this multi-lateral netting procedure used, the payment flows actually transferred between participants only amount to around 2% of the gross actually settled.

The Settlement Process
For each participant CLS keeps an account which consists of several sub-accounts, one for each currency included in CLS. A foreign exchange transaction is settled between the two parties by debiting the sub account for the currency that has been sold and at the same time crediting the sub account for the currency that has been bought. As a result of these simultaneous account movements, the settlement risk is eliminated.

Foreign exchange transactions that are to be settled via CLS must generally be sent to CLS by midnight before the value date in question. CLS then matches and stores them in a database. From 07:00 Central European Time (CET) the instructions are settled sequentially by irrevocably debiting the sub accounts for the currency that has been sold and at the same time irrevocably crediting the sub accounts for the currency that has been bought (gross settlement). As a result, during the course of the settlement process the settlement members accumulate a net short position in the currencies in which they (and their customers) are overall net sellers and a net long position in the currencies in which they are overall net buyers. Foreign exchange transactions are settled on the CLS accounts on a gross basis.

The Funding Process
In principle, the cash flows due could be transferred via an international commercial bank to which all settlement members and CLS are connected. If this bank were to fail, however, this would endager not only the payment system itself but also the solvency of the participants, since they have to hold considerable assets with the bank in order to meet their payments as they fall due. In addition, this solution will also make it difficult to obtain short-term liquidity via central banks and, ultimately, participants are not minded to let an international commercial bank - and thus a potential competitor - have their trade data.

In order to overcome these serious short comings, CLS has been granted direct access to the central banks of the currencies involved and to the large value payment system settling in central bank money. Foreign exchange transactions pay-ins and pay-outs pass through the accounts which CLS and the participants hold with the central banks. Therefore, the opening times of the large value payment systems have been coordinated in such a way that there is a common time-window for all the currencies settled so that the funds on the central bank accounts can be moved between the payee and the payer in the PvP system.

In order to start the settlement process without exposing CLS to a credit risk, participants must first transfer part of their net short positions in the respective currencies to CLS (a process commonly known as "Pay-in"). Because of the netting procedure, settlement members have to pay in to CLS only their net short positions in the individual currencies. This corresponds to the cummulative net short positions arising from the foreign exchange transactions of the day in question sent to CLS for settlement. If a participant has a net long position in a currency, it does not need to make any pay-ins in this currency at all on this value date but receives corresponding pay-outs from CLS. So while the instructions are settled on a gross basis, funding is on a net basis. Funding, as per CLS terminology, denotes pay-ins and pay-out of funds.

Since settlement members have direct access to all large-value payment systems used for the eligible currencies in only a very few cases, for funding purposes they use what are known as "nostro agents".

CLS Operational Timeline
In order to settle a foreign exchange transaction via CLS both parties must submit their instructions by no later than 00:00 CET via SWIFT message. As soon as they have been received, the instructions of both participants are validated, authenticated and matched (trade matching).

Once the submission deadline of 00:00 CET has expired, CLS sends the settlement members an initial pay-in schedule with the due pay-ins, based on participant's net short position. System participants may thus estimate their liquidity requirement in the individual currencies for the upcoming settlement cycle. Between 00:00 CET and 06:30 CET further instructions may be entered into the system, mainly in the form of what are known as "in/out swaps" inorder to reduce liquidity requirements.

From 06:30 CET, CLS calculates the final net short positions of all participants in the respective currencies and draws up the revised pay-in schedule. The settlement and funding cycle then commences. While settlement usually lasts from 07:00 CET to 09:00 CET, the funding process runs alongside it between 07:00 CET and 12:00 CET.

CLS pay-outs on net long positions also takes place step by step between 07:00 CET and 12:00 CET. Payouts are calculated according to a complex algorithm which, among other things, prioritises currencies and settlement members with high account balances. If all instructions can be settled, then at the end of a settlement day all pay-ins will have been paid out to the payees and CLS will have a zero balance on its central bank accounts.

CLS is held by its shareholders, who are banks and other financial institutions actively engaged in FX trading and/or settlement. For a detailed understanding of CLS, please refer my reading material on CLS.

Trade Lifecycle

Forex Exchange business is traditionally organised into two units: Sales & Trading and Operations. The current practice is to organise it into three units: Front office, Middle office and Back office.

Front Office
The traditional Sales & Trading unit is now called the front office. The front office does both the sales and risk management. Risk management consists of the following aspects. The front office manages the risk of the organisation by one or all or any of the combinations of the above four risk aspects. Depending on the nature of business they deal, the front office is further categorized as follows:
For engineering new products, there may be a separate "quants" team to assist the front office, but usually product engineering is a cross-market function. In a word, the front office is the profit center of business.

Middle Office
The job of a Middle Office is risk measurement and performance evaluation. Both market risk and counterparty credit risk are handled by the middle office. Performance evaluation consists of measurements in risk-adjusted return (RAR) terms, attribution and benchmarking. Middle office functions may also involve documentation, confirmation, profit and loss calculations, etc. An independent and skilled middle office implies strong internal controls, which is the main defense against fradulent trading and internal frauds.

Back Office
Back office handles much of the post-trade processing of trades. The following are some of the functions handled by the back office.
Process Flow
The following picture depicts the trade or process flow in an foreign exchange trading organisation.

This is also called as Client On Boarding. It is a one time process that establishes the business relationship with the counterparty. The parties will access each others technical sophistication, legal structure, credit worthiness, and agree on operational practices and procedures. Usually, the parties use a standard legal document(s) to document their terms of dealings. Such standard legal documents are also commonly alled as "Master Agreements". The following are a few of the master agreements that are used in the market.
On all the above, the ISDA document is the most commonly used.

Trade Execution and Capture
Trade is executed by the front office through different means, such as phone, voice broker, electronic order matching or negotiated dealing systems (e.g. Reuters Dealing 3000, EBS) and internet based systems. After the trade is executed, trade data is captured in the front office systems. This data is then mixed with Static and Reference Data to make further and meaningful sense to the trade, a process known as "Trade Enrichment". After trade enrichment, the trade is confirmed with the counterparty to make it legal.

Under this process, the payments and receipts from multiple trades due on the same day in the same currency and with the same counterparty are netting into a single amount. Netting can be bilateral or multi-lateral. In many countries, there are special local clearing with multilateral netting for USD, which nets all or some current payments into a single amount of the local currency.

Settlement in forex consists of transfering the traded currencies by both the counterparties. This is done by debiting and crediting the nostro accounts maintained with corresponding banks. If one of the currency is a local currency, it is settled in the local clearing. The payment instructions are sent through SWIFT. Depending on the time zone of the payment center, payment instructions may have to be sent a day in advance. For example, banks in Europe and North America must send settlement instructions one day in advance for the Far East currencies. The difference in time-zone makes the payment-versus-payment (PvP) method of settlement impossible with conventional practices and technology. Therefore, to reduce the settlement risk, Continuous Linked Settlement (CLS) has been constituted to reduce risk in the system. CLS has been discussed in a separate section.

Nostro Reconciliation
This is the last stage in the trade lifecycle. Accounting entries will be passed in the internal records at different stages in the trade lifecycle. Reconciliation consists of matching the entries in the internal records with those in the nostro account. Entries in the internal records record what should occur, and those in the nostro account record what has occured. If both of them match, then trade has retired in the correct manner.

Exceptions, Investigations, Repairs and Escalations
While processing the FX trades, there could be errors. The errors could occur at trade execution, confirmation, netting, settlement or nostro reconciliation stages. All these errors need to be investigaged and repaired. The same also needs to be escalated to the senior managmeent.

Exception is said to have occured when the processing of trade deviates from the established procedures. It needs to be documented, investigaged and resolved. It must also be reported to senior management. All exceptions have cost implications and thus impact profitability and may also elevate the operational risk.

Accounting and Financial Control
Netting, settlement and nostro reconciliation involve passing entries into ledgers which effect profit and loss. Thus, the firm should have robus processes to handle how, when and what time the accounting entries have to be passed, along with financial control.


The forex trade starts as a position and ends in the nostro account. In between it may be held in suspense account or as an off-balance sheet item. In this reading material, we will not discuss all aspects of accounting of forex transactions. We will limit ourselves to the discussion of the basic concepts and types.

Basically, there are four different types of accounting that needs to be carried out, depending upon the trade scenario. The following lists the scenarios.
Position Taking
All trades for which the rate of exchange between the two currencies is fixed will enter the position book. Position here denotes exposure to market risk. The purpose of position is to indicate the extent of price risk that the bank is exposed to at any point of time. Position is maintained currency-wise and independently by front office and back office.

For example, let's consider a EUR/USD trade in the books of Bank of America whose home currency is USD and whih has bought EUR in the deal. Further, let's assume that the deal amount is EUR 1 million and the price is 1.5000. Thus, the two deal amounts of the trade are EUR 1 million and USD 1.5 million. This would be recorded in the books of BofA as follows:

Currency: EUR
Trade Reference Purchase Sale Position
Trade reference: 0001 1,000,000 0 1,000,000

Currency: USD
Trade Reference Purchase Sale Position
Trade reference: 0001 0 1,500,000 1,500,000

From this position, the trade is posted into various accounts, depending on the nature of trade, as mentioned above. If both currency amounts are settled on the same day as the trade day, the trade is posted in the General Ledger. If one currency is settled immediately and the other is settled on a future date, it implies that there is a financing component to the transaction, and therefore it is posted in a Suspense Account. If both the currency amounts are to be settled on a future trade, it is posted as a Off-Balance Sheet Item.

Trades for which settlement occurs on the same day i.e. T+0
If trades are settled on the same day then the entries can directly be passed into the general ledge. The following could be the entries.

EUR A/c Dr.         1,000,000
      to USD A/c     1,500,000

Trades in which one currency is settled and the other currency is yet to be settled
Suspense account is used to record and store trades in which one currency amount is settled and the other currency amount is yet to be settled. All trades in which financing is involved falls under this category such as foreign clean instruments and foreign currency export bills discounted by bank. The suspense account may be designated as "Foreign Clean Instruments Discounted Account" and "Exports Bill Discounted Account". These accounts are maintained currency-wise. The following could be the journal entries.

For Clean Instruments and If dollar is paid but EUR receipt is anticipated

EUR - Clean Instruments A/c Dr.         1,000,000
      to USD A/c                 1,500,000

If it is a bill and If dollar is paid but EUR receipt is anticipated

EUR - Export bill discounted A/c Dr.         1,000,000
      to USD A/c                     1,500,000

Trades for which the rate of exchange between the two currencies is fixed but settlement will be done on a future date i.e. all forward contracts
All forex trades for which the rate of exchange between the two currencies is fixed but will be settled on a future date will be recorded as "Off-Balance Sheet" items. All forward contracts come under this category. They are maintained currency-wise and separately for Forward Purchase Contracts (FPC) and Forward Sale Contracts (FSC). The following could be the journal entries.

EUR FPC A/c Dr.         1,000,000
      to USD FSC A/c     1,500,000

Wash Accounts
Forex trades not involving home currency must still be accounted in home currency in books. One of the reasons for this is to account for trading profits and losses in home currency for tax and reporting purposes. The home currency equivalent is derived by employing the "wash-rate" for the trade, which is in addition to the actual trade price/rate.

Consider the same example of EUR/USD discussed above, but for a bank in India, instead of Bank of America. Let's suppose the bank is "State Bank of India (SBI)". The local or home currency for SBI is Indian Rupees or INR.

The bank whose home currency is INR, has bought EUR 1 million at 1.5000. The wash rate that is to be applied to this trade is the market price of BC/QC (BC stands for Base Currency and QC stands for Quoting Currency) prevailing at the time of the trade. Let's suppose that the EUR/INR rate at the time of the trade is INR 75. The INR equivalent deal amount is INR 75 million. The folowing would be the journal entries in the books.

If the settlement happens on T+0
EUR A/c Dr.         1,000,000
      to USD A/c     1,500,000


INR - EUR Wash A/c Dr.         7,50,00,000
      to EUR A/c           7,50,00,000

If at a later date the trade is offset or unwinded, a corresponding reverse entry is made. For example, if EUR/USD rate is 1.5100 at the time of reversing, the following entries are passed:

USD A/c Dr.         1,510,000
      to USD A/c     1,000,000


EUR Dr.               7,50,00,000
      to INR-EUR Wash A/c   7,50,00,000

Currency: EUR A/c.
Particulars Debit Amount Particulars Credit Amount
To USD 1,000,000 By INR-EUR Wash 7,50,00,000
To INR-EUR Wash 7,50,00,000 By USD A/c 1,000,000

Currency: USD A/c.
Particulars Debit Amount Particulars Credit Amount
To EUR 1,510,000 By EUR 1,500,000
By Balance c/f 10,000

The trading book is generally marked to market on a daily basis.

The commercial book is marked-to-market on a monthly or weekly basis. This excercise is called "revaluation" and is meant for assessing profit/loss and reporting purposes. The accounting entries for profit/loss are passed at longer intervals of quarter or year.

For mark-to-market/revaluation of ledger accounts, the current spot rate is used. For mark-to-mark/revaluation of suspense and off-balance items, the relevant forward rates are used.

Currency Derivatives

Currency derivatives can be categorised as per venues and as per type of contracts. As per venues, it can be categorised as follows: As per type of contracts, it can be categorised as follows: Some contracts are traded only in exchanges, some in OTC markets and a few in both exchange and OTC markets. The following table shows this aspect.
Contract Type Exchange Traded OTC Markets
Currency Forwards
Currency Futures
Currency Options
Currency Swaps
In the following paragraphs, these products are discussed.

Currency Forwards
Currency forwards are very useful for exports and importers. Let's consider the case of an exporter.

For Exporters
Let's assume that Infosys (an Indian software company) exports USD 100,000 worth of software to Bell Labs of USA on 1st January 2019. Bell Labs would want to pay to Infosys in USD. However, Infosys being an Indian company has, in general, no much use of dollars. It would want to covert those dollars into Indian rupees so that it can pay salaries and other office expenses in Indian rupees. Usually, in any international trade there is a gap of 2 to 3 months from the time a produce/service is exported till the full and final payment is received. Let's assume that Bell Labs is liable to pay USD 100,000 on 31st March 2019. Infosys can convert the USD that it receives on 31st March 2019 at the market rate of exchange prevailing on 31st March 2019. However, it is quite possible that the exchange rate on 31st March 2019 could have increased, say to Rs. 75/-, or decreased, say to Rs. 65/-. If the rate increases to Rs. 75/-, Infosys would get Rs. 75,00,000/- in local currency (INR). If the rate drops to Rs. 65/- then it would get Rs. 65,00,000/-.

Rather than bearing the currency risk, it can go to a bank in India, say to State Bank of India (SBI), on 1st January 2019 and ask it to provide an exchange rate that it can commit on 31st March 2019. Infosys, in general, would be afraid that if the rates fall, it would realise a lesser amount in INR. If SBI also thinks that the rate would fall then it may not commit itself to any such rate. However, if SBI thinks that the exchange rate may increase in 3 months time then it may enter into a contract with Infosys wherein it commits a exchange rate that it would abide by on 31st March 2019, irrespective of the exchange rate prevailing on that date. Let's assume that SBI offers a rate of Rs. 72/- for 31st March 2019. If Infosys thinks that the rate is good then it may commit itself to this contract. This contract is called a "Forward Contract". It is made on a particular date but the settlement of the contract happens on a future date. On 31st March 2019, irrespective of the prevailing market price, the participants will exchange the dollars at Rs. 72/-. That means, on 31st March 2019, Infosys will surrender USD 100,000 to SBI and SBI will pay Rs. 72,00,000 to Infosys. If the exchange rate on that date is Rs. 65/-, then Infosys would consider it to be luckly because without the forward contract, it would have received only Rs. 65,00,000/-. If the exchange rate is Rs. 75/-, then Infosys would have lost the opportunity to convert the dollars at a better rate, as it has committed itself to the rate of Rs. 72/-.

The forward contract is a derivative. All derivatives are zero-sum games and thus only one party can win and the amount won by that party will be equal to the amount lost by the opposite party. You can consider it to be a "loser to pay game".

For Importers
Let's assume that Larson & Toubro (L&T), an Indian construction company) imports earth moving equipment from Catterpillar of USA on 1st January 2019 for USD 100,000. Caterpillar would want it to be paid in USD. Let's assume that the payment is due on 31st March 2019. To make this payment, L&T would need to approach a bank and purchase dollars and remit it through the banking channels into Caterpillar's bank account. Let's further assume that the current USD rate is Rs. 70/-. If it wishes to make the payment now then its liability would be INR 70,00,000 (100,000 x 70). However, since the due date is on 31st March 2019, L&T may consider investing the Rs. 70,00,000/- in a bank account deposit or elsewhere, earn a return on it and then make the payment to Caterpillar on 31st March 2019. However, the exchange rate on 31st March 2019 can change either in favour or against L&T. For instance, if the exchange rate changes to Rs. 75/-, then L&T would have to pay Rs. 75,00,000/- to procure 100,000 dollars. If the exchange rate drops to Rs. 65/- then it would have to pay only Rs. 65,00,000/- to buy 100,000 dollars. L&T, being a construction company and not FX trading company, may not be interested in leaving its liability to uncertain currency rates. It can, hence, approach a bank, say State Bank of India (SBI), on 1st January 2019 and ask it to provide a forward rate for 3 months, i.e. for 31st March 2019. Let's say that SBI provides a rate of USD/INR = 71/-. If L&T is interested in this rate then it may accept it and thereby agree to this forward contract. Once agreed, irrespective of the market rate on 31st March 2019, L&T will pay Rs. 71,00,000/- to SBI and buy USD 100,000 from it. In this way, it can freeze its liability and protect itself from foreign exchange rate fluctuations.

Currency Futures are OTC contracts. They are not traded in any exchange. They are customised contracts entered into by parties to suit their underlying business requirements.

Currency Futures
All futures are standardised contracts traded on exchanges, and currency futures are no different. These are standardised contracts created by the exchange. The following are some of the standard features of these contracts.

Standard Features: The below paragraphs briefly describe these features.

Contract Size or Unit of Trading
In Forwards, the parties are free to enter into a contract of whatever size they wish. For example, they may buy and sell USD 10,000 or USD 1 million or USD 134,568. The contract size depends on the requirements of the parties. If its a commercial deal then the contract size will depend on the underlying exposure of the client. If it is an inter-bank deal then it would depend on the underlying position that the bank want to cover or expose itself to. In Futures, however, the contract is standardised and is decided by the exchange. The contract size is decided taking into account the nature of the market, liquidity condition and risk management aspects. For example, a EUR/USD Futures contract size could be EUR 1000 and multiples thereof. This means, one can buy a minimum of EUR 1000 or multiples thereof such as EUR 2,000, EUR 3000, EUR 4,000, etc., and not any other quantity in between.

The "Unit of Trading" and "Contract Size" in most cases is one and the same. The Unit of Trading is the number of a particular security that is used as the acceptable quantity for trading on the exchanges. For example, the following is the unit of trading on Bombay Stock Exchange (BSE) for various currency futures contracts.

Sl No Currency Pair Unit of Trading
1 USDINR 1 (It denotes 1000 USD)
2 EURINR 1 (It denotes 1000 EUR)
3 GBPINR 1 (It denotes 1000 pound sterling)
4 JPYINR 1 (It denotes 100,000 Japanese Yen)

The following is the unit of trading on Chicago Mercantile Exchange (CME) for some currency pairs. (I have not enlisted the unit of trading for all currency pairs as the list would be very long considering the number of currency pairs that are traded on CME.)

Sl No Currency Pair Unit of Trading
1 GBP/USD 62,500 British Pounds
2 AUD/CAD 200,000 AUD
3 CHF/JPY 250,000 CHF
4 EUR/JPY 125,000 EUR
5 GBP/USD (E-Micro) 6,250 British Pounds

Lot Size
In general, the contract size and lot size are the same. However, sometimes it is possible that even though the minimum trading unit is defined, the exchange may specify that only a certain minimum units of the contract have to be traded for every order. For example, if unit size is 1000 EUR and lot size is 10. This means that even though the contract size is 1000 EUR, one will not be able to buy or sell 1000 EUR. The minimum that they need to buy or sell is 10,000 (lot size 10 x contract size 1000 EUR).

Maximum Quantity Order
This is the maximum number of untis that can be bought or sold per order.

Tick Size
It refers to the minimum amount of negotiation that is allowed by the exchange. In other words, it is the minimum amount of movement of a trading instrument that is allowed by the exchange. For instance, let's say the current price of USD/INR is Rs. 70/-. A buyer has placed an order to buy USD in the market at Rs. 68/-. Tick size is Rs. 1/-. A seller can place an order at Rs. 68/- and match his order or negotiate with the buyer by quoting an alternate price. The question here is can the seller quote Rs. 68.0001 as his asking price. The answer for this depends on the tick size allowed by the exchange. If it were a forward contract then he could have asked or negotiated for any amount he wishes. However, in Futures contract, he needs to do it as per the tick size. If the exchange tick size is Rs. 1/- then he can either make a counter offer for say Rs. 69, 70, 71......... and so on but not values of Rs. 69.5, etc. In essence, the tick size governs the minimum movement of the currency in either direction.

Expiry Date
All futures contracts have a certain duration after which they expire or come to an end. The date on which the contract mandatorily comes to an end is called as "Expiry Date". In some exchanges, the contracts are allowed only for short durations such as 1 month, 2 months, etc. In some exchanges, the contracts are allowed for both short and long durations, even up to 7 or 10 years into future.

Contract Symbol
Exchange provide for trading of various contract types and upon so many underlying instruments. Though a full description is available, for trading purposes it is convenient to have a unique contract type short name or symbol by which the contract type can be identified. For instance, "USDINR" refers to the USD/INR currency pair. Similarly, "EURINR" refers to the Euro/INR currency pair contract and so on.

Contract Description
The contract description provides a brief description of the type of the contract. For example, the following is the description of a "USDINR" contract traded on National Stock Exchange, India.

"Underlying/Order Quotation:- The exchange rate in India Rupees for US Dollars".

Time/Trading Hours
Some exchanges operated round the clock, while others work only for a specific period during the day. For example, the following are the working times in some exchanges.

Sl No Instrument Exchange Trading Time
1 USDINR NSE Monday to Friday - 9am to 5pm
2 GBPUSD CME Sunday to Friday - 6pm to 5pm
3 JPYUSD ICE Everyday 8pm to 5pm

Price Precision
The price precision determines to what decimal points the negotiations can be done. The exchange specifies this in their "Contract Specifications" section. Usually, for currencies, the accepted price precision is upto 4 decimals.

How to trade futures?
Parties are free to enter futures contracts, subject to the limitations imposed by the contract specifications and exchange rules. To trade a contract one has to select the following: Let us understand this by using the example of the exporter that we used in our currency forward section.

The exporter was facing the risk of USD rate going down. He handled the problem by entering into a forward contract with a bank. The disadvantage with such a contract is that if he wanted to exit the contract then he will require the consent of the bank. Alternatively, he may go to an exchange and take a futures contract.

Futures being traded on exchanges can be bought and sold only through exchange registered brokers. Once he finds a broker, he will have to give the following details to the broker.

The following can be the same order.

Sl No Particulars Order Details Description
1 Market Side Sell The exporter is not worried about price increase.
His fear is price decrease as it would reduce his realisation.
2 Contract USDINR The currencies concerned are USD and INR and hence the
contract has to be on USD and INR currency pairs.
3 Contract Expiry March contract Instead of contract duration, the exchange notifies the contract expiry date.
The contrat expiry dates are standardised and are different for every exchange.
For example, in India both BSE and NSE have last Thursday as the contract expiry date.
In CME, the third Wednesday is the contract expiry date.
4 Contract Size 100 contracts The total exposure of the exporter is USD 100,000.
Let's assume that the minimum contract size in the exchange is USD 1000.
Thus the exporter has to take 100 contracts (100,000 divided by 1000)
5 Type of Order Market or Limit If the exporter wants to negotiate the price then he/she would
need to select a limit order; else, a market order.
6 Price INR 71/- This depends on the current market conditions. However, lets say that
the exporter wants to sell his dollars @ Rs. 71/- then he/she can specify
that number to that broker.

Once the above information is given, the broker would pass that information (or order) into the exchange and wait for it to be matched. If the order gets confirmed then the broker will receive a confirmation, which shall be sent to the customer/client.

Let's suppose that this transaction (or order) was concluded on 1st January 2019. From 1st January 2019 till expiry of the contract i.e. let's assume 15th March 2019, the exporter has the following three options:- The exporter had bought a contract which allows him to sell USD 100,000 at a future date. If he is not interested in the contract then he can sell the contract that he had bought at the prevailing market price. He may make a profit or loss in this trasaction.

The exporter can cancel the contract by taking an opposite contract. In the above example, he sold an contract initially. Therefore, he can buy a similar contract which will result in the cancellation of his position in the exchange. Had he bought a contract initially then he would have to sell it to cancel it.

The exporter can simply not do anything and hold on to the contract till the expiry date. On expiry date, the exchange automatically settles the contract. Settlement can be either physical or cash settlement. In physical settlement, the exporter will have to deliver USD 100,000 to the exchange (via his broker) and receive Rs. 71,00,000/- into his account (via the broker). In cash settlement, the exchange compares the price of the contract with that of the currency market price of the underlying (USD rate on that date) and settles the difference in cash. For example, if the USD rate on that date is Rs. 68/-, then the difference is Rs. 3/-, which is to the advantage to the exporter. The exchange would pay Rs. 3,00,000/- of the exporter, as his bet that the exchange price will move down has been correct.

Currency Options
Currency options are similar to security options, but they have their own peculiarities. Just like a normal option the buyer of the currency option pays a premium to the seller (writer) of the option. In return, the seller of the option guarantees to buy or sell a certain units of the underlying assets at a fixed price on a particular day in future. However, they are different in the following ways.

First, each option is simultaneously a call and put. Forex rate involves two currencies, expressing the value of one in terms of the other. For example, consider a long call option on EUR on the forex rate of EURUSD.

Long EUR Call = Right to buy EUR by paying USD

            this can also be stated as..........

            Right to sell USD by receiving EUR = Long USD Put

Thus, every FX option is simulateously a call and put in different currencies with the same market side. In the above example, Long EUR Call is also Long USD Put. In fact, the standard notation is to specify both option types simultaneously ("Long EUR Call/USD Put").

Premium Quotation for FX Options
The usual style of quoting premium in FX option is the same as the spot price quotation: that is, number of quoting currency (QC) units ("pips") for unit base currency (BC). There are also other, less common styles of quotation: percentage of BC amount; percentage of QC amount; and BC units ("pips") per unit BC.

Options are usually cash settled. Physically settlement is rare and may be practiced in OTC markets.

Currency Swap
Currency swap differs from interest rate swap in three features, as follows.
  1. The two interest amounts exchanged under the swap are denominated in different currencies.
  2. Apart from the interest exchange, it has an additional exchange which is the capital gains or losses in the exchange rate between the two currencies.
  3. The exchange of principal may be actual or notional.
Because the currency of the amount is different, all combinations of fixed-floating exchanges are possible, as shown below, each of which is given a specific name.

Nature of exchange Name of the swap
Fixed-for-floating Cross currency swap
Floating-for-floating Cross currency basis swap
Fixed-for-fixed Cross currency coupon swap
Notice that the fixed-for-fixed swap is not possible in interest rate swap. It is only possible in currency swap.

The above additional features bring about the following changes in the quotation of the swaps.
Let's take an example to understand currency swap.

Cross Currency Swap

In the above example, company ABC is based out of London which raises pound denominated loan from the London market. It has to pay a fixed pound interest rate on this loan. It intends to invest the money in the US market. To do that it needs dollars. It goes to the FX market and converts its pounds to dollars at an exchange rate of say GBP/USD = 1.2. It takes the dollars and invests them into the US market on which it will receive returns in US dollars. At this juncture, it is exposed to exchange risk on interest and principal arising from the changes in exchange rate between GBP and USD.

The company can hedge this risk by entering into a swap with a swap dealer. It can, under the swap agreement, agree to receive fixed interest in GBP and pay fixed interest in USD (the money that it receives in USD from its US investments). By doing so, the company can use the GBP interest that it receives from the swap dealer to pay the GBP interest obligation that it owes to the London bank.

In the above arrangement, the company will have to make sure that the type of GBP interest rate that it receives in the swap should be the same as the GBP interest rate that it pays on its loan - i.e. both are fixed or both are floating.

If the company has converted GBP principal into USD principal in the forex market, then there should not be any exchange of principal, because the company now does not have EUR principal to be exchanged under the swap. If the company has not converted GBP into USD in the forex market, then the company will exchange EUR principal for USD principal in the swap. Accordingly, both versions (i.e. principal exchange can be notional or actual) are possible. Currency swap is a risk management too, while the currency conversion is cash management. When the principal amounts are not exchanged, currency swap is used for risk management. When they are exchanged, currency swap is used for both risk and cash management.

There could be two reasons for separating risk and cash management functions (and therefore not exchanging principal in currency swap). First, the loan and currency swap are contracted at different time. Cash management is more pressing than risk management and therefore currency conversion is executed immediately in forex market, followed by hedging through currency swap. Second, the company opts to execute the currency conversion and currency swap with different institutions because of the competitive quote for products.

Let's us now consider the exchange of capital gains/loss, which is linked to whether the principal exchange is notional or actual.

If Principal exchange is notional
Since the principal is not exchanged at the beginning, the re-exchange at the end does not arise. The company has to buy GBP in the spot forex market and repay the loan. If the market now is 1.22, there will be a loss of GBP 16,393.45 (as originally, the GBP 1 million was converted into USD 1.2 million but on reconversion it could only get back on GBP 983,606.55). The currency swap, being a currency risk management tool, will compensate the company for this loss. Similarly, if the spot forex price is 1.18, the company would gain GBP 16,949.15 (as originally, the GBP 1 million was converted into USD 1.2 million but on reconversion it could get back GBP 10,16,949.15). However, this profit would be passed to the currency swap counterparty. In all cases, the company having hedged the currency risk through currency swap, the cost of GBP purchase to the company should be exactly the same as the sale price at the beginning, and any gain/loss will be to the account of the currency swap counterparty, not the company's.

If Principal is actual
The exchange of capital gain/loss does not arise in this case. The company exchanges the principal amounts at the spot forex rates prevailing at the beginning, and the re-exchange will be exactly at the same rate. It is like you take a mortgage loan for one million against home. For the repayment, you pay exactly the same principal amount of one million regarless of what the current market value of the home now is.

The following is the summary of exchange of principal amounts and capital gains/loss in a currency swap.
  1. Exchange of principal is notional
    1. Notional amounts quantified at the spot forex rate prevailing at the beginning.
    2. Interest amounts are periodically exchanged during swap term, based on the notional amount.
    3. At the end of the swap term, the difference between the currency spot forex rate and that at the beginning, which is the capital gain/loss, is passed on to the currency swap counterparty so that there is neither gain nor loss to the hedger.

  2. Exchange of principal is actual
    1. Principal amounts exchanged at the spot forex rate prevailing at the beginning.
    2. Interest amounts are periodically exchanged during swap term, based on the principal amount.
    3. At the end of the swap term, the principal amounts are re-exchanged at the same rate as they were exchanged at the beginning. In other words, the computation of capital gain/loss does not arise.

Market to Market (MtM) in a Currency Swap
Interest rate swap changes in value because of changes in interest rate. Currency swap changes its value because of change in interest rate and changes in spot forex rate. The changes in interest rates are about 1% ~ 2% a year, but the changes in forex price can be 15% ~ 20% a year. Therefore, if the counterparty defaults in the swap, the replacement cost of the trade with another will be higher in currency swap than in interest rate swap. To mitigate the elevated counterparty credit risk, currency swap is subjected to mark-to-market (MtM), and the MtM dates usually coincide with interest payment dates. The following example illustrates this.

Terms Details
Currency pair EUR/USD
Swap type Cross currency coupon swap
Principal/Notional EUR 1 million
Interest rates 3% for EUR and 4% for USD
Payment frequency Annual
Swap tenor 3 years

Let's assume that the following are the spot forex rates for the purposes of principal exchange and mark-to-market

Time FX Rate
Beginning 1.30
1 year 1.31
2 years 1.29
3 years 1.32

The MtM cash flows are capital gain/loss in nature, they are always exchanged regardless of whether the principal amounts are exchanged or not. There are two parties to this transaction - Party A and Party B. Party A is the buyer of this cross currency swap; Party B being the seller. The buyer of a cross currency swap is the party willing to pay the base currency in exchange for receiving the quoting currency. The currency pair is EUR/USD. Thus, Party A will pay EUR and receive USD. This can also be thought-of as a borrow-lend transaction, wherein Party A is willing to lend EUR and borrow USD.

If principal exchange is not involved, then there won't be any exchange of principal at the beginning of the trade. If principal exchange is involved, then Party A will lend EUR 1 million to Party B and simultaneously Party B will lend USD 1.3 million to Party A. The first exchange will happen at the end of the first year. The exchange will be of the interest amounts. Considering that Party A has borrowed USD, interest on USD 1.3 million @ 4% on USD is payable by him to Party B. Similarly, Party B has borrowed EUR. Interest on EUR 1 million @ 3% is payable by him to Party A. The respective interest amounts are EUR 30,000 and USD 52,000. Party A will need to pay USD 52,000 to Party B and receive EUR 30,000 from him.

Apart from the interest exchange, the capital gain/loss will need to be exchanged during MtM. The exchange rate at the beginning of the contract was 1.3. It is 1.31 at the end of first year. The EUR has appreciated against USD by USD 0.01 (or we can say that USD has depreciated against EUR). This depreciation of USD is a loss to Party A (lender of EUR). The reason is something like this: Party A has converted his EUR 1 million into USD 1.3 million (whether notionally or in real, it does not matter) at an initial exchange rate of EUR/USD = 1.3. If he were to recovert his USD 1.3 million back to EUR, then he will only get USD 9,92,366.41 at the current exchange rate of EUR/USD = 1.31. This loss of EUR 7,633.58 (or USD 10,000) needs to be compensated by the counterparty (i.e. Party B). Therefore, apart from the interest transfer, there would also be an capital gain/loss transfer of EUR 7,633.58 (or USD 10,000) by Party B to Party A. Another way to look into this problem is as follows: Party A had taken USD 1.3 million earlier, but at current spot rate of 1.3, he should have received USD 1.31 million. Therefore, the difference of USD 0.01 million is not received by Party A.

The second interest exchange will happen at the end of 2nd year. Party A has to pay to Party B interest @ 4% on USD 1.31 million for 1 year(remember: after the MtM the notional value is adjusted as per the current exchange rate. Thus, the USD notional for MtM purposes would be USD 1.31 million. Similarly, Party B will have to pay Party A interest @ 3% on EUR 1 million for 1 year. The respective interest amounts would be USD 52,400 and EUR 30,000.

Apart from the interest exchange, the capital gain/loss for the 2nd MtM would be based on the difference in FX rates. The previous FX rate was 1.31; the current FX exchange rate at the end of 2nd year is 1.29. USD has appreciated against EUR. As per the concept explained earlier, there is a gain of EUR 15,503.87 (or USD 20,000) to Party A, which is equal to the loss made by Party B. Therefore, Party A will need to pay to Party B EUR 15,503.87 (or USD 20,000).

The third and final interest exchange will happen at the end of 3rd year. Party A has to pay to Party B interest @ 4% on USD 1.29 million for 1 year (notional is as per the current exchange rate. please refer to the explanation provided above). In return, Party B has to pay to Party A interest @ 3% on EUR 1 million for 1 year. The respective interest amounts are USD 51,600 and EUR 30,000.

If principals are not exchanged then the capital gain/loss MtM would be on the difference between the current exchange rate and previous exchange rate i.e. 1.32 and 1.29. The difference is 0.03 USD. Who has to pay to whom? USD has depreciated against EUR. There is a loss of EUR 22,727.27 (or USD 30,000) to Party A. This amount will have to be paid by Party B.

If principal is exchanged then it shall be exchanged at the current exchange rate i.e. EUR/USD = 1.29. Party A will receive EUR 1 million and Party B will receive USD 1.29 million.

The following table shows the cash flows with and without exchange of principal.

With exchange of principal - In the books of Party A
Year Description FX Rate Party A - EUR Receipts Party A - EUR Payments Party A - USD Receipts Party A - USD Payments
On Effective Date Transfer of Principal 1.3 n.a. EUR 1 million USD 1.3 million n.a.
End of year 1 Interest exchange 1.31 EUR 30,000 n.a. n.a. USD 52,000
Capital gains/loss exchange n.a. n.a. USD 10,000 n.a.
End of Year 2 Interest exchange 1.29 EUR 30,000 n.a. n.a. USD 52,400
Capital gains/loss exchange n.a. n.a. n.a. USD 20,000
End of Year 3 Interest exchange 1.32 EUR 30,000 n.a. n.a. USD 51,600
Capital gains/loss exchange n.a. m.a. n.a. n.a.
Re-exchange of principal EUR 1 million n.a. n.a. USD 1.29 million
Summary Total of interest receipts EUR 90,000
Total interest payments USD 1,56,000
Total MtM received USD 10,000
Total MtM paid USD 20,000
Net MtM loss paid to Party B (X) USD 10,000
USD re-exchange amount (Y) USD 1.29 million
Total principal returned (X + Y) USD 1.3 million This amount is equivalent to the original exchanged amount under the contract

Without exchange of principal - In the books of Party A
Year Description FX Rate Party A - EUR Receipts Party A - EUR Payments Party A - USD Receipts Party A - USD Payments
On Effective Date Transfer of Principal 1.3 n.a. EUR 1 million USD 1.3 million n.a.
End of year 1 Interest exchange 1.31 EUR 30,000 n.a. n.a. USD 52,000
Capital gains/loss exchange n.a. n.a. USD 10,000 n.a.
End of Year 2 Interest exchange 1.29 EUR 30,000 n.a. n.a. USD 52,400
Capital gains/loss exchange n.a. n.a. n.a. USD 20,000
End of Year 3 Interest exchange 1.32 EUR 30,000 n.a. n.a. USD 51,600
Capital gains/loss exchange n.a. m.a. USD 30,000 n.a.
Summary Total of interest receipts EUR 90,000
Total interest payments USD 1,56,000
Total MtM received USD 40,000
Total MtM paid USD 20,000
Net MtM gain USD 20,000
Total loss suffered by Party B USD 20,000 This is equivalent to: if the beginning FX rate of 1.3 and end FX rate of 1.32 are considered directly

In MtM of currency swaps, the usual practice is to keep the base currency amount constant during swap term and vary the quoting currency amount, because this is how the spot forex price is quoted.

Non-Deliverable Swap (NDS)
What is NDF to conventional forward, the NDS is to conventional currency swap. In a conventional currency swap, the parties agree to: NDS is a currency swap that has compulsory cash-settlement for both interest payments and principal exchange. Typically, one currency is USD ("Settlement Currency") and the other an emerging market currency ("Reference Currency") which is dealt on "non-deliverable" basis but is converted into equivalent Settlement Currency amount and settled. The following are the features of NDS.

Because of non-deliverable status, principal is never exchanged at the beginning. Only the notional amounts for the two currencies are agreed, based on the spot forex rate prevailing in the fixing date attached to the swap's start date.

The interest rate for Settlement Currency is either fixed or floating, but the interest rate for the Reference Currency is fixed in almost all cases.

The periodic interest amounts in the Reference Currency are converted into equivalent Settlement Currency amount at the spot forex rate prevailing on the Fixing Date attached to the interest payment dates. With this, both interest amounts (one is a payment and the other is a receipt) are denominated in the same currency; and they are netted out and the net amount is settled. If the interest payment dates for both currencies do not coincide, then netting will not be possible, the amount converted into equivalent Settlement Currency amount is settled.

At the end of the swap term, there shall be no principal re-exchange because it was not exchanged at the inception. However, to complete the currency risk management function of NDS, the difference in the spot forex rate prevailing on the fixing date attached to the swap's start date and the spot forex rate prevailing on the fixing date attached to the swap's end date is converted into equivalent Settlement Currency amount at the spot forex rate prevailing on the fixing date attached to the swap's end date; and is settled. The currency fixing methodology is similar to that in NDF.


Updation History
First updated on 21.07.2019