International Finance

Module No V
(Balance of Payment)
It is a systematic record of all economic transactions between
the residents 'of a given country and the residents of other
countries-rest of the world-carried out in a specific period of
time, usually a year.
 Components of BOP
Item/Year 2009-10
Credit Debit Net
A. Current account
1. Merchandise 182163 299491 -117328
2. Invisibles (a+b+c) 161245 82328 78917
a) Services 93791 59586 34205
i) Travel 11859 9342 2517
ii)Transportation 11147 11934 -787
iii) Insurance 1600 1286 314
iv) G.n.i.e. 440 526 -86
v) Miscellaneous 68744 36499 32245
of which: Software services 49705 1469 48236
Business services 11645 18626 -6981
Financial services 3736 4736 -1000
Communication services 1229 1389 -160
b) Transfers 54432 2318 52114
i) Official 532 473 59
ii) Private 53900 1845 52055
c) Income 13021 20425 -7404
i) Investment income 12107 18720 -6613
ii) Compensation of employees 914 1705 -791
Total Current account (1+2) 343408 381819 -38411
 A) Current account
It captures the effect of trade link between the economy and rest of the
world.
1) Merchandise Trade :It includes exports and Imports.
2) Invisibles
Gnie: Government not included elsewhere: It relates to receipt and
payments on government account not included elsewhere as well as
receipts and payment on account of maintenance of embassies and
diplomatic missions and offices of international institutions such as
UNO,WHO,etc.
Credits includes allocation made for the embassy expenditure in India
out of rupee proceeds of sales in India of US surplus agricultural
commodities
A) Current account
Transfers: It represent all receipts and payments without a quid
pro quo. They include items like aid and grants received from
/extended to foreign governments, migrants transfer,
repatriation of savings, remittances of family maintenance
Contribution and donations to religious organizations and
charitable institutions etc.

Investment Income: Remittances, receipts, and payments on

account of profits, dividends, interest and discounts including
interest charges and commitment charges on foreign loans
including those on purchase from the IMF
A) Current account
Compensation of Employees: It covers wages, salaries
and other benefits, in cash or in kind, and include those of
border, seasonal and other nonresidents workers(e.g. local
staff of embassies)
 Item/Year 2009-10
Credit Debit Net
B. Capital account
1. Foreign investment (a+b) 198089 145964 52125
a) Foreign direct investment (i+ii) 37920 18191 19729
i) In India 37182 5500 31682
Equity 27149 4242 22907
Reinvested earnings 8080 0 8080
Other Capital 1953 1258 695
ii) Abroad 738 12691 -11953
Equity 738 8057 -7319
Reinvested earnings 0 1084 -1084
Other capital 0 3550 -3550
b) Portfolio investment 160169 127773 32396
i) In India 159897 127521 32376
of which: Flls 156570 127521 29049
GDRs/ADRs 3328 0 3328
ii) Abroad 272 252 20
2. Loans (a+b+c) 73204 60982 12222
a) External assistance 4965 2917 2048
i) By India 52 420 -368
ii) To India 4913 2497 2416
b) Commercial borrowings (MT & LT) 14674 12152 2522
i) By India 974 1505 -531
ii) To India 13700 10647 3053
c) Short term to India 53565 45913 7652
i) Suppliers' Credit >180 days & Buyers' Credit 48571 43914 4657
ii) Suppliers' credit up to 180 days 4994 1999 2995
 Item/Year 2009-10
Credit Debit Net
3. Banking capital (a+b) 61499 59415 2084
a) Commercial Banks 60893 58966 1927
i) Assets 17097 15259 1838
ii) Liabilities 43796 43707 89
of which: Non-resident deposits 41356 38432 2924
b) Others 606 449 157
4. Rupee debt service 0 97 -97
5. Other capital 11209 23941 -12732
Total capital account (1 to 5) 344001 290399 53602
C. Errors & omissions 0 1746 -1746
D. Overall balance (A+B+C) 687407 673966 13441
E. Monetary movements (i+ii) 0 13441 -13441
i) I.M.F.
ii) Foreign exchange reserves (Increase-/ 0 13441 -13441
 Banking capital: It is the changes in assets and liabilities of
commercial banks,
This includes government banks, private banks, co-operative
banks.
Assets are held by foreign branches of Indian banks.
Liabilities are deposit balances held by foreign banks in India.
So increase in asset is debit and increase in liabilities is credit.
Decrease in asset is credit and decrease in liabilities is debit.
 Rupee Debt Service is the payment under rupee/rouble
agreement with Russia.It is defined as the cost of meeting
interest payments and regular contractual repayments of
principal of a loan along with administration charges in
rupees by India
Errors and omissions: It indicates the value of
discrepancies. Recording of transaction in the BOP
statement is made according to the principle of double entry
book system, certain discrepancies in estimating and timing
may result in a situation where debits are not exactly equal
to credits. Receipts are either overstated or payments are
under statedand vice -versa
Monetary movements:

a) Indias transaction s with the IMF

b) RBIs foreign currency reserves
c) Drawings(essentially type of borrowing) from the IMF
or drawing down of reserves credit items whereas
repayments made to IMF or addition made to existing
reserves are debit items.
d) It measures the effect of transactions on current and
capital account on the official reserves of the country
 IMF account: It contains purchase (credits) and re-purchases
(debits) from IMF.
SDR are a reserve account created by IMF and allocated from
time to time to member countries.
It can be used to settle international payments between monetary
authorities of two different countries.
An allocation is a credit and retirement is the debit.
Foreign exchange reserves are in the form of balances with
the foreign central banks and investment in foreign government
securities.
 Changes in official reserves

Official gold reserves (Monetary gold)

Official foreign exchange holdings ( For e.g. Reserves)
Reserve position in IMF and (IMF Quotas)
Overall Balance

Balance on current account

i) Balance of Trade: Difference between value of exports
and imports.
ii) Balance of payment: Balance of trade + Invisibles.
Balance on Capital account: It is the net inflows and
outflows on capital transactions.
It is more of private capital account becoz it excludes
movement in official reserves.
BASIC BALANCE AND OVERALL
BALANCE
Basic Balance: This is the total of balance on current
and long term items in capital account
It is overall balance less shortterm capital movements
Overall balance: It is total of balance on current
account and balance on capital account.
It is also called as official settlements balance since it
must be financed by official reserves or by other non-
reserve transactions that are substituted for reserve
transaction
 Balance of payment always balances
In accounting sense ,a BOP account always balances, because it is
prepared on the principle of double entry of book-keeping.
The total of the credit and debit entries must be equal to each
other
Balance in current A/C + Balance in capital A/C + Change in
Movements = Zero
The change in Monetary Movements reflects the overall BOP
position.
 Increase in foreign exchange reserves indicates BOP Surplus
Decrease in foreign exchange reserves indicates BOP deficit.
No change indicates
(Surplus/Deficit in Current A/C = Surplus/Deficit in
Capital A/C)
 However , actual recording of entries can rarely be complete
and accurate.
Some transaction are bound to be left out (for e.g. illegal
transactions like smuggling and havala do not appear in
official records )
Some discrepancies is bound to persist in the totals of credit
and debit entries.
These discrepancies are more likely to arise in the short run,
particularly because actual deals, shipment of goods, and the
payments do not take place simultaneously.
For this reason the balancing item E & O is inserted.
Concept of Autonomous and
Accommodating
Autonomous flows: This takes place in the ordinary
course of foreign trade. These are transaction above the
line.
Accommodating flows (induced): These flows takes
place to equalize the BOP. These are transactions above the
line.
Credits Amt (Rs) Debits Amt (Rs)
Current A/C Current A/C
Autonomous 800 Autonomous 930
Transactions Transactions
Export of goods 550 Imports of goods 500
Export of services 150 Imports of 280
services
Unrequited Unrequited
receipts payments
Gifts 75 Gifts 20
Indemnity 25 Remittances 60
Capital A/C Capital A/C
Accommodating Accommodating
transaction transaction
Borrowings 200 Loans 70
Receipts 1000 Receipts 1000
 CAUSES OF DISEQUILIBRIUM IN BOP
Change in foreign Demand:
Inflationary or deflationary pressure: Inflation will
increases the imports as the goods become relatively cheaper and
vice-versa, making it favorable or unfavorable
Development expenditure:
Increase in cost structure of export sector: Higher
wages, higher prices of raw materials, or higher rate of inflation.
 Decrease in supply: Agir.production falls due to the failure in
monsoon, IND. Prod. Falls due to labour strike, shortage of raw
materials.
Appreciation of exchange rate:
Increased debt Burden: Increase in capital inflows lead to debt
servicing like interest.
Demonstration Effect:
Population Pressure:
Political factors: political turmoil and instability majorly in African,
Gulf countries, Afghanistan etc.
MEASURES TO CORRECT THE
DISEQUILIBRIUM IN BOP
Depreciation: Under flexible exchange rate ,changes in
exchange rate will automatically adjust the BOP.
Devaluation: It is used under the fixed exchange rate
system, it means fall in the value of home currency. It is used
to wipe out the deficit. If the elasticity is high then definitely
the devaluation will work.
Import control: By Imposing quotas and tariff.
 MEASURES TO CORRECT THE
DISEQUILIBRIUM IN BOP
Export promotion: Reducing export duties , subsidies
for exports, provision of market information, arranging
exhibition, providing finance ,raw material at relatively less
cost
Exchange control: Buying and selling the foreign
exchange through central Bank to restrict the foreign
exchange.
Production of Import substitutes:
Monetary Policy: Tight monetary policy can be used to
reduce expenditure to reduce deficit and vice-versa.
Foreign Exchange rate

The foreign exchange rate is the rate at which the currency

of a country is exchanged against the currency of another
country.
 Factors affecting Foreign Exchange
Rates
GDP: It is the primary indicator of the strength of the economic activity. The growth
in GDP positively influences the foreign exchange prices of the currency and vice-
versa.
Trade Balance: A positive BOT (appreciation in the domestic currencies) and vice-
versa.
Inflation: It reduces the purchasing power of the currency which will lead to
depreciation of the exchange rate.
Employment levels: It reflect the development and stability in the economy.
Increase in empt increases the consumption and savings which leads to increase in
investment and leads to the appreciation of the domestic currency.
Interest rate differential:
Exchange rate policy:
Political factors: These events may be anticipated or unforeseen. Some of the
political developments are election, public announcements by central bank or
government officials, military takeovers, political instability etc can affect the
exchange rate.
View of Speculators:
Concepts of Foreign exchange
transactions
FIAT Currencies:
Currency that a government has declared to be legal tender,
despite the fact that it has no intrinsic value and is not backed by
reserves.
Historically, most currencies were based on physical commodities
such as gold or silver, but fiat money is based solely on faith.

The term derives from the Latin fiat, meaning "let it be done" or
"it shall be [money]", as such money is established by government
decree. Where fiat money is used as currency, the term fiat
currency is used.
 Foreign Currency:
It is defined as, the legal tender applicable in a country
outside the domestic area.
Foreign Exchange means foreign currency and includes-
Deposits, credits and balances payable in any foreign
currency.
Drafts, travellers cheque, letters of credit or bills of exchange
expressed in Indian currency but payable in foreign currency
and
Drafts, travellers cheque, letters of credit or bills of exchange
drawn by banks outside India but payable in Indian currency.
 Nostro Account It is the overseas account which is held by the
domestic bank in the foreign bank or with the own foreign branch of the
bank. For example the account held by state bank of India with bank of
America in New York is a Nostro account of the state bank of India. It is
our account with you.

Vostro Account It is the account which is held by a foreign bank

with a local bank, so if bank of America maintains an account with state
bank of India it will be a vostro account for state bank of India. It is
your account with us

From the above one can see that the account which is Nostro
for one bank is Vostro for another so when SBI opens a Nostro
account with Bank of America, it is a Vostro account for them
and vice versa.
 LORO Account:
An account held by a domestic bank in itself on behalf of a foreign
bank.
The latter in turn would view this account as a Nostro account.
A Loro is our account of their money, held by you.
Loro account is a record of an account held by a second bank on behalf
of a third party;
i.e, my record of their account with you.
In practice this is rarely used, the main exception being complex
syndicated financing.
Their account with them.

Ex.: Just like State bank Of India maintaining an account

with foreign correspondent say BTC, New York, Canara
Bank may also maintain a Nostro Account with them. When
SBI advises BTC New York for transfer of funds to Canara
Bank Account with them, Canara Bank Account is titled as
Loro Account "i.e. their account with you".
 Correspondent banks are used by domestic banks in order to service
transactions originating in foreign countries, and act as a domestic bank's
agent abroad.
This is done because the domestic bank may have limited access to
foreign financial markets, and cannot service its client accounts without
opening up a branch in another country.
Maintaining the foreign currency a/c and receiving and making
payments on behalf of the counterparty (principal) bank.
Providing temporary overdrafts as and when necessary.
Providing credit reports on companies located in the country of the
correspondent bank.
Assisting the principal bank in all agency functions such as presenting of
documents, advising of LC , confirmation of LC etc.
 Foreign Exchange Market

a) The foreign exchange market provides the physical and

institutional structure through which the money of one country
is exchanged for that of another country, the rate of exchange
between currencies is determined, and foreign exchange
transactions are physically completed .
b) A foreign exchange transaction is an agreement between a buyer and
seller that a fixed amount of one currency will be delivered for some
other currency at a specified rate.
c) Foreign exchange means the money of a foreign country; that is,
foreign currency bank balances, bank notes, checks, and drafts.
FUNCTIONS
Transfer function: It helps the transfer the purchasing
power between the countries. It utilizes the instrument like
bills of exchange, bank drafts, telegraphic transfers, etc.
Credit functions: normally with maturity of 12 months.
Hedging function: It is undertaken to avoid a risk with a
change in exchange rate.
FUNCTIONS
Speculating function: It is function which speculator
undertakes and it is risky.
Arbitrage function: It refers to the process by which an
individual purchases foreign exchange in a low price market
for a sale in a high price market for the purpose of making
profit. It is the riskless profit.
 FOREIGN EXCHANGE DEALERS
Market Participants: Investment Bankers deals in inter
bank Market.
Commercial Bank: These are major players in the market
who buy and sell the currencies.
Exchange Brokers: This facilitates deals between the
banks.
Central Bank
Investment Management Firms: An investment
management firm with an international portfolio buys and
sells the currencies
FOREIGN EXCHANGE DEALERS
Hedge Funds
Commercial companies: Often trades in the small amount
Traders and Investors
Money Changers: Are authorized by the RBI
Restricted Money changers can only buy while others can buy as
well as sell the currencies. for e.g. some hotels, firms have given
the licenses by the RBI.
Retail clients
 Gold Standard
This is the oldest system.
This was in operation till first
world war.
It is based on value of gold
There are three kinds of gold
standard that have been adopted
since 1700.
The Gold specie
Gold Exchange
Gold bullion Standard
 Gold Specie
In this system actual gold coins or coins with
content of gold were in circulation
The unit of currency is linked with the gold
coins
Gold along with silver coins were also in use
There were fix conversion ratio such as 5 silver
coins = 1 gold coins
Gold were used for trading of goods of services.
Value of gold coin is same as the gold contents.
Gold should be freely exported and imported.
The supply of gold determine the liquidity and
consequently its value.
Some used only gold for conversion called as
monometallic
And some used gold and silver called as
bimetallism.
Bimetallism: Before 1875
A double standard in the sense that both gold and silver were
used as money.
Some countries were on the gold standard, some on the silver
standard, some on both.
Both gold and silver were used as international means of payment
and the exchange rates among currencies were determined by
either their gold or silver contents.
Greshams Law implied that it would be the least valuable metal that
would tend to circulate.

2-39
 Gold Specie
Eastern roman empire made use of
gold coin called Byzant.
US dollar was minted as gold and
silver coin till 1862 and continued
along with paper notes till 1933.
The four main basic unit was the cent,
the dime, and an eagle
Dime is 10 cents, a dollar is 10 dime,
and an eagle is 10 dollars.
The international gold standard was
established by Britain in 1821, using
the Gold Sovereign as their unit.
By 1871 Germany established a strict
gold standard currency called
Reichsmark and by 1870,s France
started using it.
Gold Specie
The net trade imbalance between two countries would get
settled through transfer of gold reserves.
This would result in reduced in money supply and
commodity prices in the deficit country and increased money
supply and inflation in the surplus country.
This would make commodities more attractive in the deficit
country leading to a reversal in the trade imbalance and help
to achieve equilibrium of trade.
This in-built mechanism for balancing trade in the Gold
Standard was called Price Specie Adjustment Mechanism.
 Gold Points was a term which referred to the rates of foreign
exchange likely to cause movements of gold between countries
adhering to the gold standard.
Application
In accordance with the law of supply and demand, the concept
determined that the fluctuating limits of currency fixed the cost of
money between the place where the bill was drawn and that in
where it was payable. In the exchanges rates between gold-
standard countries, these limits were known as the gold points, for
the reason that, if the price of foreign bills rose above the upper
limits determined by the exchange rate, countries would find it
cheaper to export gold than to export bills for the purpose of
settling international accounts. Conversely, if the exchange rate
fell below the lower limit of the determined rate, countries would
find it cheaper to import gold than to sell bills to foreign
creditors.
Gold bullion Standard
Gold Bullion Standard
The reconstructed fixed exchange rate regime differed from the pre-war
standard into two aspects.
Gold coin no longer circulated as a currency and the inter-convertability
of bank notes with gold coins were substituted by much more heavier
minimum weight of gold bars.
In gold Bullion standard, monetary authorities hold stock of Gold.
Currency in circulation is a paper currency note. (or silver coin or low
value metal coin).
On these paper notes there is written promise that if you demand , on
submission of this note, they would give you specified quantity of gold.
Hence the paper currency is pegged with the gold and is unconditionally
converted in to gold, on demand.
The gold per note was fixed by the issuing authority (gold to bullion
ratio).
 The USA introduced Gold Bullion paper currency notes in
1862 and they existed along with actual gold eagle coin
dollars.
Dollar coin or note was equivalent to 1.50 g (23.22 grains)
of gold.
Mechanism of Exchange of Two currencies (Mint
par of Exchange or Par value System)
The mechanism of establishing exchange rates between currencies under
the gold Standard was the Mint Par of Exchange.
The exchange rate between two currencies was represented by the ratio
of the official gold prices for the two currencies.
Example
If 1 ounce of gold in USA = USD 400
And 1 ounce of gold in Germany = DEM 600
then 1 USD = = DEM 1.5000

Exchange rate established in this manner were called CENTRAL

EXCHANGE RATES or MINT PARITIES.
It is basically gold that was getting exchange, either actually or through
promises.
Hence in bullion standard, if one currency is worth
 In Gold exchange standard system, currency is exchanged for
another currency at a specified ratio, as promised by the
monetary authority.
Another currency with which it is pegged is called as reserve
currency.
Reserve currency (Dollar and Pound) were in turn,
convertible to real gold as these were in glld bullion
standard.
The gold exchange standard (1870-1914)

Towards the end of the 19th century, some of the remaining silver
standard countries began to peg their silver coin units to the gold
standards of the United Kingdom or the USA.
In 1898, British India pegged the silver rupee to the pound
sterling at a fixed rate of 1s 4d, while in 1906, the Straits
Settlements adopted a gold exchange standard against the pound
sterling with the silver Straits dollar being fixed at 2s 4d.
At the turn of the century, the Philippines pegged the silver
Peso/dollar to the US dollar at 50 cents.
A similar pegging at 50 cents occurred at around the same time
with the silver Peso of Mexico and the silver Yen of Japan.
When Siam adopted a gold exchange standard in 1908, this left
only China and Hong Kong on the silver standard.
Classical Gold Standard:
1875-1914
Highly stable exchange rates under the classical gold standard
provided an environment that was conducive to international trade
and investment.
Misalignment of exchange rates and international imbalances of
payment were automatically corrected by the price-specie-flow
mechanism.
Classical Gold Standard:
1875-1914
There are shortcomings:
The supply of newly minted gold is so restricted that the growth of
world trade and investment can be hampered for the lack of sufficient
monetary reserves.
Even if the world returned to a gold standard, any national
government could abandon the standard.
Advantages
Long-term price stability has been described as the great virtue of the
gold standard. Under the gold standard, high levels of inflation are rare,
and hyperinflation is impossible as the money supply can only grow at
the rate that the gold supply increases.
Economy-wide price increases caused by ever-increasing amounts of
currency chasing a constant supply of goods are rare, as gold supply for
monetary use is limited by the available gold that can be minted into
coin.
High levels of inflation under a gold standard are usually seen only when
warfare destroys a large part of the economy, reducing the production of
goods, or when a major new source of gold becomes available.
In the U.S. one of those periods of warfare was the Civil War, which
destroyed the economy of the South, while the California Gold Rush
made large amounts of gold available for minting.
 The gold standard limits the power of governments to inflate
prices through excessive issuance of paper currency.
It provides fixed international exchange rates between those
countries that have adopted it, and thus reduces uncertainty in
international trade.
Historically, imbalances between price levels in different countries
would be partly or wholly offset by an automatic balance-of-
payment adjustment mechanism called the "price specie flow
mechanism.
The gold standard makes chronic deficit spending by governments
more difficult, as it prevents governments from inflating away the
real value of their debts.
A central bank cannot be an unlimited buyer of last resort of
government debt. A central bank could not create unlimited
quantities of money at will, as there is a limited supply of gold.
 Disadvantages
Deflation rewards savers and punishes debtors. Real debt burdens therefore rise,
causing borrowers to cut spending to service their debts or to default.
Lenders become wealthier, but may choose to save some of their additional
wealth rather than spending it all. The overall amount of expenditure is therefore
likely to fall.
Deflation also prevents a central bank of its ability to stimulate spending.
However in practice it has always been possible for governments to control
deflation by leaving the gold standard or by artificial expenditure.
The total amount of gold that has ever been mined has been estimated at around
142,000 metric tons. Assuming a gold price of US$1,000 per ounce, or $32,500 per
kilogram, the total value of all the gold ever mined would be around $4.5 trillion.
This is less than the value of circulating money in the U.S. alone, where more
than $8.3 trillion is in circulation or in deposit (M2). Therefore, a return to the
gold standard, if also combined with a mandated end to fractional reserve
banking, would result in a significant increase in the current value of gold,
which may limit its use in current applications.
For example, instead of using the ratio of $1,000 per ounce, the ratio can be
defined as $2,000 per ounce effectively raising the value of gold to $9 trillion.
However, this is specifically a disadvantage of return to the gold standard and
not the efficacy of the gold standard itself. Some gold standard advocates
consider this to be both acceptable and necessary[30] The amount of such base
currency (M0) is only about one tenth as much as the figure (M2) listed above.
 Many economists believe that economic recessions can be largely
mitigated by increasing money supply during economic downturns.
Following a gold standard would mean that the amount of money would
be determined by the supply of gold, and hence monetary policy could
no longer be used to stabilize the economy in times of economic
recession.
Such reason is often employed to partially blame the gold standard for
the Great Depression, citing that the Federal Reserve couldn't expand
credit enough to offset the deflationary forces at work in the market.
Opponents of this viewpoint have argued that gold stocks were available
to the Federal Reserve for credit expansion in the early 1930s, but Fed
operatives failed to utilize them.
Monetary policy would essentially be determined by the rate of gold
production. Fluctuations in the amount of gold that is mined could cause
inflation if there is an increase, or deflation if there is a decrease. Some
hold the view that this contributed to the severity and length of the Great
Depression as the gold standard forced the central banks to keep
monetary policy too tight, creating deflation.[29][38] Milton Friedman
however argued that the main cause of the severity of the Great
Depression in the United States was the Federal Reserve, and not the gold
standard, as they willfully kept monetary policy tighter than was
required by the gold standard. Additionally, three increases by the
Federal Reserve in bank reserve requirements in 1936 and 1937, which
doubled bank reserve requirements[40], lead to yet another contraction
of the money supply.
 Although the gold standard gives long-term price stability, it does in the
short term bring high price volatility. In the United States from 1879 to
1913, the coefficient of variation of the annual change in price levels was
17.0, whereas from 1943 to 1990 it was only 0.88.
It has been argued by among others Anna Schwartz that this kind of
instability in short-term price levels can lead to financial instability as
lenders and borrowers become uncertain about the value of debt.
Some have contended that the gold standard may be susceptible to
speculative attacks when a government's financial position appears weak,
although others contend that this very threat discourages governments'
engaging in risky policy (see Moral Hazard).
For example, some believe the United States was forced to raise its
interest rates in the middle of the Great Depression to defend the
credibility of its currency after unusually easy credit policies in the 1920s.
This disadvantage however is shared by all fixed exchange rate regimes
and not just limited to gold money. All fixed currencies that appear weak
are subject to speculative attack.
If a country wanted to devalue its currency, it would generally produce
sharper changes than the smooth declines seen in fiat currencies,
depending on the method of devaluation.
 SPOT AND FORWARD EXCHANGE RATE
Spot Rate: it is the single outright transaction involving the
exchange of two currencies at a rate agreed on the date of
the contract for value of delivery within two business days.
For e.g. If AD quotes
Rs 43.46-48/US$ This is the two way quotes of the spot
rate.
Trade date: The day the deal is struck
Value date or settlement date: the day the exchange of
currencies takes place is the value date.
THREE DIFFERENT SETTLEMENT
MATURITIES
Ready Transactions or a cash transaction: Exchange of
currency takes on the day itself.
Value TOM: Exchange of currency takes on the next
business day.
Spot Transaction: Exchange of currency takes on the
second business day.
BID and ASK Quotation
Interbank quotations are given as a bid and ask (also referred
to as offer).
A bid is the price (i.e., exchange rate) in one currency at
which a dealer will buy another currency.
An ask is the price (i.e., exchange rate) at which a dealer will
sell the other currency.
Dealers bid (buy) at one price and ask (sell) at a slightly
higher price, making their profit from the spread between
the buying and selling prices.
BID and ASK Quotation
Bid and ask quotations in the foreign exchange markets are
superficially complicated by the fact that the bid for one
currency is also the offer for the opposite currency.
A trader seeking to buy dollars with Swiss francs is
simultaneously offering to sell Swiss francs for dollars.
Assume a bank makes the quotations for the Japanese yen.
The spot quotations on the first line indicate that the banks
foreign exchange trader will buy dollars (i.e., sell Japanese
yen) at the bid price of 118.27 per dollar.
The trader will sell dollars (i.e., buy Japanese yen) at the ask
price of 118.37 per dollar.
Direct quote and Indirect quote
A direct quote is a home currency price of a unit of foreign
currency. An example, using Mexico and the United States
(home country) is: $0.1050/Peso.
An indirect quote is a foreign currency price of a unit of
home currency. An example, using Japan and China (home
country) is: 14.75/Rmb.
European terms and American terms
Most foreign currencies in the world are stated in terms of the
number of units of foreign currency needed to buy one dollar. For
example, the exchange rate between U.S. dollars and Swiss franc
is normally stated
SF1.6000/$, read as 1.6000 Swiss francs per dollar.
This method, called European terms, expresses the rate as the foreign
currency price of one U.S. dollar. An alternative method is called
American terms.The same exchange rate above expressed in American terms
is $0.6250/SF, read as 0.6250 dollars per Swiss franc.
Under American terms, foreign exchange rates are stated as the
U.S. dollar price of one unit of foreign currency.
Note that European terms and American terms are reciprocals:
 Reciprocals. Convert the following indirect quotes
to direct quotes and direct quotes to indirect
quotes:
a. Euro: 1.02/$ (indirect quote); 1/1.02 = $0.98/i (direct)
b. Russia: Rub 30/$ (indirect quote); 1/30 = $0.0333/Rub
(direct)
c. Canada: $0.63/C$ (direct quote); 1/0.63 = C$1.5873/$
(indirect)
d. Denmark: $0.1300/DKr (direct quote); 1/0.1300 =
DKr7.6923/$ (indirect)
FORWARD TRANSACTION
It is also known as forward outright rate. The forward is the
transaction involving the exchange of two currencies at a rate
agreed on the date of the contract for a value or delivery at
the same time in future (more than two days).
FORWARD TRANSACTION
Transaction shows the forward
a) Suppose the trade date is April 1
b) Value date is calculated one month after the spot date (i.e.
April ) ,therefore the value is may 3. If May 3 is holiday
then May 4.
OUTLINE
Defining Exchange Rate
Measuring Exchange Rate Movements
Appreciation/Depreciation of a currency
Exchange Rate Equilibrium
Factors that influence Exchange Rate Movements
MEANING OF EXCHANGE RATE AND
MEASURING CHANGES IN EXCHANGE RATES

Value of one currency in units of another currency

A decline in a currencys value is referred to as depreciation
and an increase in currencys value is called appreciation.
If currency A can buy you more units of foreign currency,
currency A has appreciated and foreign currency depreciated
If currency A can buy you less units of foreign currency,
currency A has depreciated and foreign currency appreciated
APPRECIATION/DEPRECIATION
Percentage change in value US $
- Old value of rupees per $
New Value of rupees per unit of $

--------------------------------------------------------- X 100
Old value of rupees per $

Percentage change in value of Rupees

- Old value of $ per unit of Rupees
New Value of $ per units of Rupees

-------------------------------------------------------------- X 100
Old value of $ per unit of Rupees
EXCHANGE RATE EQUILIBRIUM
Forces of Demand and Supply
Demand for foreign currency negatively related to the price
of foreign currency
Supply of foreign currency positively related to the price of
foreign currency
Forces of demand and supply together determine the
exchange rate
DEMAND FOR ($)

Price in ($)
Exchange rate Demand for ($)

50 100

40 200

30 300

20 400

10 500
 DEMAND FOR ($)
60

50

40
Price of ($) EXchange rate

30

20

10

0
0 100 200 300 400 500 600
Demand for ($)
SUPPLY OF ($)

Price in ($) Exchange

rate Supply of ($)

50 500

40 400

30 300

20 200

10 100
 SUPPLY OF ($)
Price in ($) Exchange rate
60

50

40
Price in ($)

30

20

10

0
0 100 200 300 400 500 600
Supply of ($)
EQUILIBRIUM EXCHANGE RATE
Price in ($)
Exchange rate Demand for ($) Supply of ($)
50 100 500
40 200 400
30 300 300
20 400 200
10 500 100
EQUILIBRIUM EXCHANGE RATE

D
S
Excess
Supply

$1=30
Excess
S
Demand
D

300 Units of Foreign

Currency($)