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Foreign Exchange Basics Flashcards

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1
Q

Who are the actors in the foreign exchange markets

A

central banks, commercial

banks, brokers etc.

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2
Q

What is the function of foreign exchnag markletys?

A
  • The foreign exchange market acts as a central focal point wherein prices of various
    currencies are discovered.
  • Enables the investors to hedge or minimize their risks
  • Enables the traders to arbitrage any inequalities
  • Provides an investment / trading avenue to entities who are willing to expose
    themselves to this risk.
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3
Q

What is the difference between foreign currency and foreign exchange?

A
  • In the context of India, any currency other than Indian rupees is foreign currency.
  • Foreign exchange includes currency, drafts, bills, letters of credits and traveler
    cheques which are denominated and ultimately payable in foreign currency,
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4
Q

What does PPP stand for?

A

Purchasing Power Parity

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5
Q

What is the the most important

factor for variations in exchange rates?

A

Difference in inflation rates between two countries

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6
Q

What if domestic inflation is high?

A

If domestic inflation is high, it means domestic goods are costlier than foreign goods.
This results in higher imports creating more demand for foreign currency, making it
costlier. (In other words the value of domestic currency will decline).

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7
Q

If a basket of goods cost Rs470 in India and $10 in US then it is quite natural that the
exchange rate should be…

A

Rs47/$1

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8
Q

by which formula can the PPP be expressed?

A

PPPr = Spot rate (1+rh)/(1+rf) where rh is inflation rate at home; rf is the inflation rate of foreign country

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9
Q

What is the main weakness of the theory?

A

It is not only inflation, which affects foreign currency movements.

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10
Q

Which effect does PPP ignore?

A

PPP ignores substitution effects – i.e. instead of importing goods might be substituted.

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11
Q

What is the interest rate parity theorem?

A

The second most important factor in determining exchange rates after PPP theory.
• Money tends to move towards country offering a higher interest rate thereby resulting
in more demand for the foreign country’s currency.
• If interest rates in Japan are lower than interest rates in US then Japanese investors
would prefer to invest in US which would result in more demand for US $ in Japan
(this will cause US$ to appreciate in Japan).

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12
Q

For what do interest rates provide?

A

Interest rates provide the basis for computing forward rates as under:
Forward rate = Spot rate x (1+If)/(1+Ih)

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13
Q

What is the balance of payment p[osition?

A

• The BOP position has a big impact on the value of a nation’s currency.
• A big or consistent deficit would mount a pressure on the currency of a nation as
deficits require payments in foreign currency.
• In the case of a fixed currency rate scenario – the local currency would be devalued
thereby making imports costlier and exports cheaper.
• However in the free rate scenario a big or consistent deficit would be a forewarning for
depreciation of a nations currency

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14
Q

Howe does the government sometimes intervent?

A

At times the government would intervene by purchasing or selling foreign exchange to
control pressures on the nations currency.

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15
Q

What influences the exchange rates?

A

Market expectation as regards interest rates, inflation, taxes, BOP positions etc would
affect the foreign exchange rates.

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16
Q

What also infleunces the rates?

A

Speculators including treasury managers of banks, by virtue of their buying and selling,
tend to influence the rates.

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17
Q

What is a direct quote?

A

No of units of the domestic currency per unit of foreign currency
• E.g. 1$ = Rs 49.50 is a dollar direct quote of an Indian rupee in India. However the
same quote when quoted in US is not a direct quote for an American.

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18
Q

What is an indirect quote?

A

No of units of a foreign currency per fixed number of domestic currency;
• E.g. Rs 100 = $0.2245

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19
Q

What is the bid price?

A

Bid is the price at which a dealer is willing to buy another currency and offer is the rate
at which he is willing to sell the currency.

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20
Q

What is a spread?

A

Spread is the difference between the bid rate and the offer rate and usually represents
the profit margins that a dealer expects to make.

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21
Q

Thrtough which are all transactions in India routed?

A

In India all buy and sell transactions are routed through the US $.
• Hence all deals involving any other currency would necessarily involve converting in
US$ and then converting the US$ into INR.
• Thus if an Indian importer wishes to buy Yen he would first have to sell rupees and
buy dollar; then he would sell dollar and buy yen.
• The banker would obtain the Yen / $ rate from Singapore or Tokyo and then apply the
Rs /$ rate to determine the amount of rupees required to buy the desired Yen.

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22
Q

What is the spot rate?

A 
Spot rate : Rate quoted for transactions that will settled two business days from the
transaction date (T+2)
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23
Q

What is the forward rate?

A

Forward rate : Rate quoted for transactions that will be settled beyond two business
days at a mutually agreed rate and date.

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24
Q

What is the cash rate?

A

Cash rate : Rate quoted for transactions that will settled on the same day (T+0)

25
Q

What is the Tom rate?

A

Tom rate : Rate quoted for transactions that will be settled in one business day form
the date of transaction (T+1)

26
Q

What is an ap[preciation of a currency?

A

A currency is said to have appreciated if it is able to purchase more of the other
currency.
• E.g. if Rs /$ is 1$ = Rs45 and it changes to 1$ = Rs46 then dollar is said to have
appreciated.

27
Q

What is a depreciatgion?

A

A currency is said to have depreciated if it is able to purchase less of the other
currency.
• E.g. if Rs /$ is 1$ = Rs45 and it changes to 1$ = Rs44 then dollar is said to have
depreciated and rupee appreciated.

28
Q

When is a currency at premium?

A

A currency is said to be at a premium if it is more expensive in the forward than
in the spot

29
Q

When is a currecy at discount?

A

A currency is said to be at a discount when it is quoting higher in the spot and
cheaper in the forward.

30
Q

What is arbitrage?

A

Arbitrage means buying in one market & selling in another to take advantage of price differential

31
Q

What sorts of arbitrage are out there?

A
  1. Geographical arbitrage : Buying currency in say London market & selling it in say Tokyo
  2. Triangular arbitrage : Involves three currencies and three markets (also known as
    three point arbitrage)
  3. Arbitrage in forward markets : If the spot rate + interest is greater or less than the
    forward rate there exists an arbitrage potential.
32
Q

What is a nostro account?

A

Nostro account refers to an account that a bank holds in a foreign currency in another bank. Nostros, a term derived from the Latin word for “ours,” are frequently used to facilitate foreign exchange and trade transactions

33
Q

What is a vostro account?

A

Vostro means “your account with us”.

E.g. Citibank New York may maintain a Rupee account with SBI

34
Q

What is a Loro account?

A

Loro means “their account with you”
E.g. SBI has an account with Citibank New York. When Syndicate Bank refers to this
account in any correspondence with Citibank New York it would refer it as Loro
account.

35
Q

What are telegraphic or table transfers?

A
  • Used for remittance of foreign exchange
  • Mode of transfer is telegraphic transfer.
    • Sender of money pays the money to be transferred to Authorized dealer
    • The authorized dealer is requested to make the payment in foreign currency to the
    ultimate receiver of the money.
    • Code numbers used for verifying authenticity of remittances.
    • Authorized dealer charges for this service
    • Payment received by the receiver on the same day.
    TT
36
Q

What are the buying and selling rates?

A

TT buying rates applicable for transactions where the Banks nostro account has
already been credited or will be credited without delay.
• Nostro Accounts are foreign currency account maintained at foreign centers with
correspondent banks to facilitate receipt and payment of foreign currency.
• TT selling rates are applicable where bank does not have to handle any documents/
bills

37
Q

What is a bankers draft?

A

The payer obtains a bankers draft or a cheque drawn by a foreign bank on its
correspondent bank.
• The receiver of the draft presents it for collection through his banker.
• More time consuming that Mail transfer and not a very preferred mode of transfer of
funds.

38
Q

What is a bill of exchange?

A

A bill of exchange is a written order used primarily in international trade that binds one party to pay a fixed sum of money to another party on demand or at a predetermined date.

39
Q

When are bill buzing and selling rates apply?

A

Bill buying rates is applied where the bank has to handle documents. A good example
of a situation where buying rates is applied is when export bills for collection.
• Bill selling rates is applied where the bank has to handle documents in a transaction
like payment of export bill.

40
Q

What is a letter oif credit?

A

Preferred form of payment for making trade payments.
• The importer banks requests his banker (issuing bank) to open an letter of credit.
• The letter of credit is issued through the correspondent bank which in turn will advise
the beneficiary bank (advising bank)

41
Q

What are international money orders?

A

Issued by post offices of respective countries.
• MO are issued in the currency of the issuing post office.
• The domestic post office will then convert the currency (charge a nominal fee) and pay
the same to the addressee.

42
Q

Name the four disadvantages of Euroipean Monetary Union:

A
  1. Loss of monetary independence
  2. Loss of National pride
  3. Cost of conversion
  4. Earning loss for Banks
43
Q

What is the loss of monetary independence?

A

National monetary autonomy has to be surrendered to ECB
• This would mean loss of control over economic policy, loss of right to alter
exchange rate and also loss seignorage (right to print money)

44
Q

What is the loss mof national pride?

A

Certain currencies are a matter of national pride.

• Sacrificing national currency may be politically costly and provocative.

45
Q

What is the cost of conversion?

A
  • Includes cost of printing bank notes, minting coin.
  • Withdrawal and destruction of old currency
  • Changes in information and technology and processes
  • Retraining of trained personnel
46
Q

What is the earning loss for banks?

A

Single currency reduces the earnings of the banks as it reduces the currencies in
which they can trade.

47
Q

How many major benefits are there?

A

10

48
Q

What is the saving in transaction costs?

A

By elimination of the need to hedge risks and

conversion costs

49
Q

Why is there lower inflation?

A

A centralized banking control through the ECB will be in a better
position to control inflation by efficient transfer of resources.

50
Q

Why are there lower interest rates?

A

Lower budget deficit, elimination of exchange rate risks and increased competition amongst banker will lower interest rates

51
Q

Why are there increased investments?

A

Increased investments : Low interest rates will spur capital investments resulting in growth.

52
Q

Why is there a better allocation of resources?

A

Unrestricted resource mobility results in better and

efficient utilization of resources.

53
Q

Why is there a level playing field?

A

The tendency of a country to devalue its currency to compete with others is eliminated.

54
Q

Why is pooling of exchange reserves an advantage?

A

Would result in a collective pool of around $200

billion

55
Q

What is meant by the integration of markets?

A

Single currency eliminates market imperfections for products services etc.

56
Q

What is the global currency status?

A

Euro is all set to become a global currency and will be

second only to dollar in its strength as a reserve currency

57
Q

What is capital account convertibility?

A

One of the most essential parameters for integration of

the domestic economy with the global economy

58
Q

What are the objectives of capital account convertibility?

A

➢ To deepen and integrate financial markets
➢ Increased access to global savings
➢ Discipline domestic policy makers
➢ Allow greater freedom to individual decision-making
➢ Facilitate resident Indians to invest their surplus outside the country
➢ Move capital from one country to another without hindrances

59
Q

Again, what is a nostro account?

A

Nostro Account refers to “Our Account with you”. For example if Bank of Baroda maintains
a Dollar Account with CITIBANK (US), Bank of Baroda will refer it to as Nostro A/c :
Citibank(US) meaning our account with Citibank. A Nostro A/c is a current account - no
interest is earned on the balance kept in the account; but if the account is overdrawn then
interest is charged.

Finance (11 decks)

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