Chapter 1: Introduction to Currency Markets

The foreign exchange (Forex or FX) market is the largest, most liquid financial market in the world, with daily global turnover exceeding .5 trillion (according to the Bank for International Settlements - BIS Triennial Survey). It operates as an over-the-counter (OTC) decentralized global network connecting commercial banks, central banks, institutional investors, multinational corporations, and retail traders across global financial centers.

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1.1 Brief History of Foreign Exchange Markets

The mechanism for pricing and settling foreign currencies has evolved through distinct monetary regimes over centuries:

1. The Gold Standard (1870–1914)

• Mechanism: Currencies were backed by physical gold reserves. Each participating country fixed the price of its domestic currency in terms of a specific weight of gold.
• Exchange Rate Parity: The exchange rate between any two currencies was determined by their mint par of exchange (ratio of their gold content).
• Automatic Adjustment: Trade imbalances were self-correcting through the Price-Specie Flow Mechanism (gold outflow $\rightarrow$ reduced domestic money supply $\rightarrow$ falling domestic prices $\rightarrow$ increased export competitiveness).
• Demise: Suspended during World War I as governments printed paper money to finance military spending, leading to severe inflation and loss of gold convertibility.

2. The Inter-War Period (1914–1944)

• Marked by economic fragmentation, hyperinflation (e.g., Weimar Republic in Germany), and competitive currency devaluations ("beggar-thy-neighbour" policies) during the Great Depression.
• Countries abandoned gold convertibility, resulting in extreme currency volatility, tariff wars, and severe contraction of international trade.

3. The Bretton Woods System (1944–1971)

• Creation: Established at the United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire (1944). It created the International Monetary Fund (IMF) and the World Bank.
• Gold-Dollar Standard:
  • The US Dollar was pegged to gold at a fixed rate of 5 per troy ounce.
  • All other participating currencies were pegged to the US Dollar within a tight band of $\pm$ 1%.
  • Central banks were obligated to intervene in foreign exchange markets to maintain their exchange rates within the permissible band.
• Triffin Dilemma & Collapse: The US ran chronic balance of payments deficits to supply global liquidity. As foreign dollar holdings vastly exceeded US gold reserves, convertibility became untenable.

4. The Smithsonian Agreement (December 1971)

• Attempted to rescue fixed exchange rates: the US Dollar was devalued to 8 per ounce of gold, and currency fluctuation bands were widened to $\pm$ 2.25%.
• The band structure proved unsustainable under speculative pressure, leading to the collapse of fixed rates in March 1973.

5. The Floating Exchange Rate Era & Jamaica Agreement (1976)

• The Jamaica Agreement (January 1976) officially legalized floating exchange rates and formally demonetized gold in the international monetary system.
• Key accords shaped major currency trends thereafter:
  • Plaza Accord (September 1985): G5 nations (US, UK, France, West Germany, Japan) agreed to engineer a controlled depreciation of the overvalued US Dollar against the Japanese Yen and Deutsche Mark.
  • Louvre Accord (February 1987): G6 nations agreed to halt the decline of the US Dollar and stabilize major exchange rates around prevailing levels.

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1.2 Major Currencies and Currency Pairs

ISO 4217 Currency Codes

The International Organization for Standardization (ISO) established ISO 4217 three-letter currency codes. The first two letters represent the country code (ISO 3166-1 alpha-2), and the third letter represents the initial of the currency name:

Classification of Currencies

1. Major Currencies: The most heavily traded global currencies: USD, EUR, JPY, GBP, CHF, AUD, CAD, NZD.
2. Reserve Currencies: Currencies held in significant quantities by central banks as part of their foreign exchange reserves. The US Dollar dominates (~58-60%), followed by the Euro (~20%), Japanese Yen (~5%), and Pound Sterling (~5%).
3. Commodity Currencies: Currencies of countries whose economies depend heavily on the export of natural resources/commodities:
   • AUD (Australian Dollar): Strongly correlated with iron ore, coal, and gold prices.
   • CAD (Canadian Dollar): Highly correlated with crude oil prices.
   • NZD (New Zealand Dollar): Correlated with dairy, agriculture, and forestry exports.

Classification of Currency Pairs

1. Major Currency Pairs: Pairs involving the US Dollar paired with another major global currency:
   • EUR/USD, USD/JPY, GBP/USD, USD/CHF, AUD/USD, USD/CAD, NZD/USD.
   • EUR/USD alone accounts for approximately 23-28% of all global foreign exchange turnover.
2. Minor / Cross-Currency Pairs: Pairs consisting of major currencies that do not include the US Dollar:
   • Examples: EUR/GBP, EUR/JPY, GBP/JPY, EUR/CHF, AUD/JPY.
3. Exotic Currency Pairs: A major currency paired with the currency of an emerging, developing, or smaller economy:
   • Examples: USD/INR (US Dollar / Indian Rupee), USD/BRL (Brazilian Real), USD/ZAR (South African Rand), USD/TRY (Turkish Lira).
   • Characteristics: Wider bid-ask spreads, lower liquidity, and higher volatility.

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1.3 Basics of Currency Markets and Peculiarities in India

Market Structure in India

The Indian foreign exchange market operates in two distinct tiers:

1. Wholesale Inter-bank Market: Authorised Dealers (commercial banks) trade among themselves and with the Reserve Bank of India (RBI). Major electronic dealing venues include Refinitiv (formerly Reuters) Dealing D2 and CCIL FX-Clear.
2. Retail / Merchant Market: Commercial banks transact with corporate entities, exporters, importers, and individuals.

Authorised Persons under FEMA, 1999

Under Section 10 of the Foreign Exchange Management Act, 1999 (FEMA), the RBI licenses entities to deal in foreign exchange:

• Authorised Dealer (AD) Category-I: Scheduled commercial banks, state cooperative banks, and select foreign banks authorized to execute all permissible current account and capital account transactions.
• Authorised Dealer (AD) Category-II: Upgraded money changers and non-bank entities authorized to execute specified non-trade current account transactions (e.g., overseas education, travel, medical treatment).
• Authorised Dealer (AD) Category-III: Select financial institutions (e.g., EXIM Bank, SIDBI, NABARD) authorized to undertake specific foreign exchange transactions incidental to their core mandate.
• Full Fledged Money Changers (FFMC): Authorized to purchase foreign currency notes and traveler's cheques from residents and non-residents, and sell foreign exchange for private and business travel abroad.

Quotation Conventions

In any currency pair quote (e.g., EUR/USD or USD/INR): 7890\text{Base Currency / Quotation (Price) Currency} = \text{Exchange Rate}7890

• Base Currency: The first currency quoted. It is always 1 unit (with the exception of Japanese Yen in India, which is quoted per 100 units).
• Quotation (Price) Currency: The second currency. It indicates how many units of quotation currency are needed to buy 1 unit of base currency.

Direct vs. Indirect Quotations

• Direct Quotation: Price of 1 unit of foreign currency expressed in terms of variable units of domestic currency.
  • Example in India: USD = ₹ 83.5000$.
• Indirect Quotation: Price of 1 unit of domestic currency expressed in terms of variable units of foreign currency.
  • Example: $₹ 1 = 0.0120 USD$.
• Historical Shift in India: Prior to August 2, 1993, Indian foreign exchange quotes were quoted on an indirect basis. Effective August 2, 1993, India officially adopted the Direct Quotation method for all merchant and interbank quotations.

Two-Way Quotations (Bid and Ask)

Market makers quote two prices simultaneously: 7890\text{USD/INR} = 83.2500 / 83.25507890

• Bid Price (83.2500): The price at which the quoting bank/market maker is willing to buy the base currency (USD).
• Ask / Offer Price (83.2550): The price at which the quoting bank/market maker is willing to sell the base currency (USD).
• Spread: The difference between the Ask and the Bid price: 7890\text{Spread} = \text{Ask Price} - \text{Bid Price} = 83.2550 - 83.2500 = ₹ 0.00507890
  • A tight spread signifies high liquidity; a wide spread indicates illiquidity or high market uncertainty.

Appreciation vs. Depreciation

• Appreciation of Base Currency: When 1 unit of base currency buys more units of quotation currency.
  • If USD/INR moves from 3.00$ to 3.50$, the USD has appreciated (+0.60%), and the INR has depreciated.
• Depreciation of Base Currency: When 1 unit of base currency buys fewer units of quotation currency.
  • If USD/INR moves from 3.50$ to 3.00$, the USD has depreciated (-0.60%), and the INR has appreciated.

Value Date and Settlement Conventions

In foreign exchange transactions, the Value Date is the delivery date when the actual transfer of funds occurs in the respective bank accounts:

1. Cash / Ready: Settlement takes place on the same day of the trade (+0$).
2. Tom (Tomorrow): Settlement takes place on the next business day following the trade date (+1$).
3. Spot: Settlement takes place on the second business day following the trade date (+2$).
4. Forward: Settlement takes place on an agreed future date beyond the spot date ( > 2$ business days).

Market Timings & Reference Rates in India

• Normal Market Hours: 9:00 a.m. to 5:00 p.m. IST on all working business days. Value Cash transactions can be executed up to 5:00 p.m. IST.
• Financial Benchmarks India Pvt. Ltd. (FBIL) Reference Rates:
  • Timing: Computed using transaction data from a 1-hour window between 11:30 a.m. and 12:30 p.m. IST on each business day.
  • Outlier Filter: Applies a $\pm$ 3 Standard Deviation (SD) rule to eliminate non-representative trades.
  • Calculation: Volume-Weighted Average Price (VWAP) of the remaining trades.
  • Publication: Published around 13:30 hours IST.
  • Published Pairs:
    • USD/INR: 1 USD in INR (quoted to 4 decimal places)
    • EUR/INR: 1 EUR in INR (quoted to 4 decimal places)
    • GBP/INR: 1 GBP in INR (quoted to 4 decimal places)
    • JPY/INR: 100 JPY in INR (quoted to 2 decimal places)

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1.4 Exchange Rate Arithmetic - Cross Rate

A Cross Rate is an exchange rate between two currencies derived from their individual exchange rates against a common third currency (usually the US Dollar).

The Chain Rule for Cross-Rate Bid and Ask

When calculating cross rates involving bid and ask spreads, always apply the market-maker rule: you buy at the market maker's Ask and sell at the market maker's Bid.

Scenario A: Direct Cross Rate Multiplication

To calculate EUR/INR from EUR/USD and USD/INR: 7890\text{EUR/INR}{\text{Bid}} = \text{EUR/USD}{\text{Bid}} \times \text{USD/INR}{\text{Bid}}7890 7890\text{EUR/INR}{\text{Ask}} = \text{EUR/USD}{\text{Ask}} \times \text{USD/INR}{\text{Ask}}7890

• Numerical Example:
  • Given Quotes:
    • $\text{EUR/USD} = 1.0850 / 1.0855$
    • $\text{USD/INR} = 83.2000 / 83.2050$
  • Calculation: 7890\text{EUR/INR}{\text{Bid}} = 1.0850 \times 83.2000 = ₹ 90.27207890 7890\text{EUR/INR}{\text{Ask}} = 1.0855 \times 83.2050 = ₹ 90.31907890 7890\text{EUR/INR Quote} = 90.2720 / 90.31907890

Scenario B: Cross Rate Division (Base Currency in Denominator)

To calculate USD/INR for JPY, where rates are quoted as USD/JPY (USD is base currency, JPY is price currency): 7890\text{JPY/INR (per 100 JPY)}{\text{Bid}} = \left( \frac{\text{USD/INR}{\text{Bid}}}{\text{USD/JPY}{\text{Ask}}} \right) \times 1007890 7890\text{JPY/INR (per 100 JPY)}{\text{Ask}} = \left( \frac{\text{USD/INR}{\text{Ask}}}{\text{USD/JPY}{\text{Bid}}} \right) \times 1007890

• Numerical Example:
  • Given Quotes:
    • $\text{USD/JPY} = 155.20 / 155.25$
    • $\text{USD/INR} = 83.2000 / 83.2050$
  • Calculation: 7890\text{JPY/INR}{\text{Bid}} = \left( \frac{83.2000}{155.25} \right) \times 100 = ₹ 53.597890 7890\text{JPY/INR}{\text{Ask}} = \left( \frac{83.2050}{155.20} \right) \times 100 = ₹ 53.617890 7890\text{JPY/INR (per 100 JPY)} = 53.59 / 53.617890

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1.5 Impact of Economic Factors on Currency Prices

Currency exchange rates are determined by supply and demand dynamics influenced by fundamental economic factors:

1. Purchasing Power Parity (PPP):
   • Asserts that in the long run, exchange rates adjust so that an identical basket of goods and services costs the same in two countries (Law of One Price).
   • If country A has higher inflation than country B, country A's currency must depreciate by approximately the inflation differential to maintain purchasing power parity.
2. Interest Rate Parity (IRP):
   • The expected forward rate differential is linked to the nominal interest rate differential between two economies.
   • Currencies offering high nominal interest rates typically trade at a forward discount, while currencies with low interest rates trade at a forward premium.
3. Balance of Payments (BoP):
   • Current Account: Measures exports and imports of goods, services, and unilateral transfers/remittances. A persistent current account deficit increases demand for foreign currencies, depreciating the domestic currency.
   • Capital Account: Measures foreign direct investment (FDI), foreign portfolio investment (FPI), external commercial borrowings (ECBs), and NRI deposits. Massive capital inflows cause the domestic currency to appreciate.
4. Foreign Exchange Reserves:
   • India's foreign exchange reserves (comprising foreign currency assets, gold, Special Drawing Rights - SDRs, and reserve position in the IMF) act as a vital cushion against sudden capital flight and currency speculative attacks.
5. Fiscal Deficit:
   • High fiscal deficits lead to increased government borrowing, potentially crowding out private investment, driving up inflation expectations, and weakening the domestic currency.

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1.6 Key Economic Indicators

Traders and corporate treasurers closely monitor regular macroeconomic releases:

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Key Exam Takeaways for NISM Series I

• Quotation convention in India switched from Indirect to Direct on August 2, 1993.
• In India, JPY/INR is always quoted per 100 units of Japanese Yen, whereas USD/INR, EUR/INR, and GBP/INR are quoted per 1 unit.
• Normal interbank and client market trading hours are 9:00 AM to 5:00 PM IST.
• FBIL computes the reference rate using electronic transactions between 11:30 AM and 12:30 PM IST, applying a $\pm$ 3 Standard Deviation outlier filter.
• Value Date conventions: Cash = T+0, Tom = T+1, Spot = T+2, Forward = > T+2.
• Cross-rate Bid is the product of underlying Bids; Cross-rate Ask is the product of underlying Asks.