Foreign Exchange Rate (Forex) : Some Basics
Foreign Exchange (Forex) Market is the trading of currencies. The foreign exchange market –Forex Market- is not a single place like NY Stock Exchange (NYSE). It is a widely decentralized 24 hour-a-day market, made up of banks and traders communicating electronically. The retail market is between individuals, non financial companies, non bank financial institutions and other customers of banks. The wholesale market is the trading between banks. This accounts for 60% or more of the total trading.
Scope of the Market:
About half the daily forex trading is done between banks in London and New York. Most of the trading involves U.S currency. Sometimes the intent is to trade one foreign currency for another and the U.S. currency is only involved as an intermediate step. When this is done the dollar is called a vehicle currency.
Foreign Exchange Rate: Some Basics
The exchange rate is the price of one country’s money in terms of another country’s money. The ‘Spot’ exchange rate is the price for immediate exchange. Immediate usually means within two working days. This amount is to about 33% of all trading. The ‘forward’ exchange rate is the price for exchange to take place at some specific time in future, often 30, 90, 140 days. This amount is to about 11% of all trading. A ‘Swap’ is a ‘package trade’ that includes both spot exchange of two currencies and a contract to the reverse forward exchange a short time later. This is useful when the parties to the swap have only a short term need for the currency. This amount is to about 56% of all trading.
Exchange rate quotation:
Quoted currency means the currency that is variable in an exchange rate quotation, base currency means that is fixed. Thus if ₤1= CAD 117.00, here sterling Pound is base currency and the CAD is the quoted currency.
Types of quotation:
In direct quotation base currency is the Foreign currency and quoted currency is the Domestic Currency and quoted Currency is the Foreign Currency (CAD1=US$0.0144).
In American terms Base currency is any currency other then USD and quoted Currency is USD( CAD1=$0.01444). In European Terms Base currency is the USD and quoted Currency is any Currency other than USD ($1=CAD75.00)
Reciprocal Quotations:
Currency can be quoted in terms of number of units of A per unit of B or, alternatively, the number of unit B per Unit of A. The two rates represents equal value and are reciprocals of each other. To convent from one method to the other, one simply divides the number 1by the rate.
Example: USD1/CAD69.50 = 1/69.50 CAD/USD
= 0.0143 CAD/USD
Cross Rate: A cross rate may be defined as an exchange rate that is calculated from two other rates. In practice, cross-rate is the exchange rate between 2 non US$ currencies.
Forward Rates: It is an exchange Rate for the transaction to be happened at some future date, but agreement for the transaction is to be done today. Forward rate is quoted either at premium (+) or at discount rate (-) over spot rate. In case of direct quotation, premium will be added to and discount will be subtracted from spot rate. The reverse is for indirect quotation.
Quotation of Forward Rates:
Forward at Premium (pm)
Forward at Discount (dis)
Forward at ‘par’ meaning the Forward Rate at Parity with Spot Rate.
Premium and Discount
The quoted currency is said to stand at a premium in the forward market if it is more expensive in the future than it is now in term of the base currency. Conversely the base currency may be said to stand at a discount relative to the quoted currency.
