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Unit 3: Foreign Exchange Market and Exchange Rates

quoted in the market is $.82. As a step to build the economy, the country is also allowing Notes
foreign investors to make investments. Various incentives are being offered by the country
to attract foreign funds. The rate of interest on one year government securities is presently
16%. This is substantially higher than the 10% rate which is presently offered on one year
US government securities.
Apex Corp. has asked you, as an employee in their international Money Market division,
to assess the feasibility of making a short term investment in this country. The amount
available for making the investment for the next year is $ 12 million.
The Apex Corp. has also come to know that the exchange rate in this country will be
market determined for the next few years. Financial managers in Apex Corp. are hence
apprehensive about the high volatility of the Currency till an equilibrium is reached. It is
expected that the value of Currency in one year will be approx. $.85. However, there is a
high degree of uncertainty attached with this value and predictions are being made that
the actual value may be 30% above or below this expected value.
Source: International Financial Management, Madhu Vij, Excel Books.

Task What problems do you think you would face as a business trying to operate in two
different foreign exchange markets?

3.3 Exchange Rate Determination

An exchange rate can be defined as the number of units of one Currency that must be given to
acquire one unit of a Currency of another country. It is the price paid in the home Currency to
purchase a certain quantity of funds in the Currency of another country. For example, it takes
about ` 48.10 to purchase one US dollar and ` 8.10 to purchase one Euro. The exchange rate is the
link between different national currencies that makes international price and cost comparisons
possible.

The Foreign Exchange Market includes both the Spot and Forward Exchange Rates. The Spot rate
is the rate paid for delivery within two business days after the day the transaction takes place. If
the rate is quoted for delivery of foreign Currency at some future date, it is called the forward
rate. In the forward rate, the exchange rate is established at the time of the contract, though
payment and delivery are not required until maturity. Forward rates are usually quoted for
fixed periods of 30, 60, 90 or 180 days from the day of the contract.

3.3.1 Foreign Exchange Quotations

The exchange rate quotation states the number of units of a price Currency that can be bought in
terms of one unit of another Currency.

Quotes in Basis Point

For most currencies, foreign exchange quotations are given to the fourth decimal place - that is
to one-hundredth of one percent or 1/10,000. This is usually called a ‘pip’. For a few currencies
like Japanese yen and the Italian lira that are relatively small in absolute value, quotes may be
carried to two decimal places and a ‘pip’ is 1/100 of the Currency unit. In a foreign Currency
market a ‘pip’ or a ‘tick’ (as it is also sometimes called) is the smallest amount by which a price
can move. ‘Pip’ is the term commonly used in the markets.

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