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About Author :
Name : Sakshi Laturiya (CA Final)
Author is CA final student, Currently associated with M/s SSRPN & Co.
Foreign Exchange Market
Foreign exchange market is a dealer market in which RBI has appointed authorized dealers to quote the bid and ask rates. Bid rate is the rate at which customer can sell the foreign currency (lower rate) and ask rate is the rate at which it can buy the foreign currency (higher rate). Direct quote of currency means 1 unit of foreign currency means how many units of home currency. Indirect quote is number of foreign currency per unit of home currency.
Example: 1$ = Rs. 60 is direct quote for India and Indirect quote for USA.
The foreign exchange market can be classified in 3 ways:
- Between RBI and Banks
- Interbank or wholesale market
- Retail market (telegraphic transfer rates)
In retail market rates are computed by charging margin on inter bank rate. Again, Market can be grouped based on settlement:
- Cash market: Settlement on the same day.
- Tom market: Settlement is on T+1 i.e 1 business day ahead.
- Spot market: Settlement is on T+2
- Forward market
- FX Swap: Combination of spot and reverse forward transaction.
Concept of overlapping exchange rates:
Consider the quotation of dollar (Rs./$) given by two banks:
- Bank A- 61.50/61.90
- Bank B- 62.20/62.50
What will happen in such situation?
Everyone will start buying dollars from bank A and selling the same in Bank B to earn the margin of Rs. 62.2-61.9 i.e Rs.0.30 per dollar without any risk and investment. This is known as arbitrage profit. To avoid such profit there is concept of overlapping exchange rates. As per it the bid rate of a bank will always be between the bid and ask rate of any quotation available in market. If this is not the case there will be arbitrage profit available and everyone will start transactions to earn such profit leading to excess demand for $ faced bank A and excess supply of $ by bank B. Bank A will increase its quotation to cover it’s short position and bank B will reduce the quotation to cover the long position. By this the scope for arbitrage will get eliminated.