Forex System
In the course of international business, forex system dealing is a business in which the foreign currency is treated like a commodity. Foreign currency is associated with commodity because neither of them can be used as a legal tender.
Today the system of barter is not in existence where commodity is used as a means of payment. Similarly, the U.S Dollars are not valid in India to settle the routine business transactions. As the commodity is sold in the market cash is acquired, likewise when foreign currency is converted into rupees in the banks dealing in foreign exchange, it can be readily used as an instrument of making payments.
Normally every trading has two aspects a) buying b) selling. A trader purchases goods from his suppliers and sells them to the buyer at an agreed price. Similarly, the banks authorized to deal in forex purchase as well as sell their commodity. I.e. foreign currency.
Purchase transaction means acquisition of foreign currency. When foreign currency is obtained by the bank it parts with the home currency. Similarly in a sales transaction, the bank obtains home currency and parts with the foreign currency.
If a bank in India issues a demand draft on London for pounds 50 it is selling the foreign forex system currency and acquiring home currency. Similarly when a traveler visits India he encashes the travelers cheque for $250 then the bank collects the U.S dollars in exchange of rupees.
Exchange quotations:
There are two methods of price quotations as illustrated below:
A stationary owner may sell his goods in the two following ways:
1 note book = $3
1 ink pen = $1
1 jotter pen = $2
Method II
For $ 9 = 3 books
For $ 9 = 9 ink pens
For $ 9 = 5 pens
The price per unit has remained constant but it is expressed differently in both the cases. According to the first method, the price is quoted per item. In the second method the price is kept constant and the number of items is varied and it reflects price per item.
The rates of exchange can be quoted in any of the ways.
U.S. $ 1= Rs. 50
Pound 1 = Rs. 42.5
DM 1= Rs. 25.75
Method ii
Rs. 100 = U.S. $ 2
Rs. 100 = pound 2.25
Rs. 100 = DM 4
Under the first method the price per unit is expressed in foreign currency in terms of home currency. This technique of pricing is known as the Home currency quotation or direct quotation. The price of foreign currency is kept constant and the value of rupees changes in terms of foreign currency. When we look at the first example we can also analyze the demand of the foreign currency. The dollar currency is widely accepted in the world.
When you observe the second method you will see that the value of rupee remains constant and the price of foreign currency is expressed in terms of rupees. This system of pricing is known as Foreign currency quotation or indirect quotation. If the demand for the foreign currency in the course of time changes then it will be shown as :
Imagine today if 1$ makes 50 Rs. And tomorrow if the dollar is overvalued then the presentation of dollars in terms of rupees will be .88 $ = 50 Rs.
The quotation of currency pricing differs from nation to nation. In the London foreign exchange market the indirect method is in vogue, whereas in the New York exchange and other foreign markets it is the direct method that is practiced.
Direct quotation is used when the trader purchases the commodity at a lower price and sells it when the price is higher. As the prime motive of the forex system trader is to make profit he sells at a profitable price. Similarly, in the foreign exchange market, he buys the foreign currency at a lower price and sells it at a higher price. For example, he may purchase US dollar at Rs. 31 and sell at Rs. 31.10. the cost of foreign currency is constant but there is a change in the home currency price.
The indirect quotation of pricing is described below:
If a fruit vendor sells 50 oranges for Rs. 100 and later if he sells 40 oranges and earns Rs. 100 obviously he has gained profit. This quotation is termed as buy high and sell low. When the problem of inflation sets into the market this method is more appropriate. When he buys he buys more units of the commodity at a certain price but when he sells he sells it at the same price but the quantity sold is less. His earning per unit of the commodity will not be affected.
Similarly in case of forex system dealing the banker acquires more units of foreign currency at a fixed price of home currency. While selling he parts with lesser units of foreign currency at a fixed unit of home currency.
For example, he may state that the buying rate is $3.2275 for Rs. 100 and selling rate is $3.2200 and the difference between the buying rate and the selling rate is the bankers margin of profit.
Spot and forward transactions:
Imagine there are two banks in the foreign exchange market; Bank of India wants to buy from Bank of Baroda pound 100000 through telegraphic transfer. The process of transfer may take place in any of the following ways
a) on the same day
b) after two days
c) after a month
The first term a) indicates cash transactions where the agreement made to purchase and sell and the receipt of payment takes place on the same day.
If the Bank of India maintains an account with Citibank and Bank of Baroda has maintained an account with Midland Bank London, then Bank of Baroda would advise the Midland bank to pay it to the Citibank London pounds 100000 and credit it to the account of Bank of India with them. Naturally this procedure is lengthy and requires some time. It may take two days it is known as spot transaction.
If the delivery of foreign currency takes place after a month it is known as forward transaction from the date of contract.
The forward rate may be costlier, cheaper or even at par with the spot rate. The difference between the spot rate and forward rate is known as forward margin. If the spot rate exceeds the forward rate then the forward margin is said to be quoted at premium and if it is lesser than the spot rate it is quoted as discount.
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