Understanding Foreign Exchange - Part 1

Series of articles on foreign exchange

Foreign exchange is any transaction that involves more than one currency. So, buying dollars with Indian rupees or selling dollars for euro or any such transaction involves foreign exchange. At this point of time, knowledge about foreign exchange is necessary as we have adopted globalization and there is easier movement of funds in and out of our country. Companies go for raising funds abroad, as funds are available at cheaper rates in global markets, than in domestic market. Similarly, in order to find customers for their products and suppliers for their inputs and for service providers Indian firms are going for cross border tie-ups.

Foreign Currency Arithmetic:

Foreign currencies are quoted against one another in three ways – direct quote, indirect quote and international quote.

To understand the concept of direct and indirect quote we can take an example of buying a pencil. We can buy a pencil for INR.2. So it can be written as,

                                                1 Pencil = INR 2 – Direct quote.

It can also be quoted as,        INR 1= ½ Pencil – Indirect quote.

So the explanation to this is, We pay a price to buy a product. If the value of one product is mentioned in terms of price, it is called direct quote. Whereas, if the purchasing power of one unit of price is mentioned it is indirect quote.

Lets go to foreign exchange now. We now want to buy one dollar. As we are buying US dollar, foreign currency, is the product and our Rupees, home currency, is the price we pay for buying the product. The bank is giving us the quotes.

Direct quote  1$ = INR 50                                       Indirect quote INR 1 = 0.02$ (1/50)

So, in this way we can understand the quotes that are mentioned. There arises a doubt for everyone. In India the price is Indian rupees and product is US Dollars. What will it be in USA?

The answer is simple. In USA , US dollars, home currency of USA, will be the price and Indian rupees, foreign currency for USA, will be the product. Hence The direct and indirect quotes get interchanged. So it will be like,

In USA,                                                                                   In India,

Direct quote INR 1 = 0.02$                                                Direct quote 1$ = INR 50

Indirect quote 1$ = INR 50                                                 Indirect quote INR 1 = 0.02$

So direct and indirect quote is the equation of home currency against foreign currency, or vice versa, in two different ways.

The third and the final type of quoting foreign exchange is the international quote or cross currency quote. International quotes are those quotes that does not involve the home currency. For example,

1 Euro = 1.3670 USD

The above given quote, is direct quote in USA , indirect quote in Euroland and International quote in any other country, for example India or china or Japan etc. So, international or cross currency quote is a foreign exchange quote that involves two or more foreign currencies, but not home currency.

So, that’s about basics on foreign exchange quotes. Following articles  will be about the next part i.e. bid and ask rate, spread and swap points.

D.Aravind(SRO 0266513)