Exchange Rate Calculations
Exchange Rate Calculations
Introduction
Exchange rate calculations are a high-weightage, numerically intensive topic in the JAIIB AFB exam. Bankers deal with foreign exchange daily — whether processing remittances, trade finance, or treasury operations. This topic covers the types of exchange rates, quotation methods, buying and selling rates, merchant rates, and practical calculation techniques.
What Is an Exchange Rate?
An exchange rate is the price of one currency expressed in terms of another. For example, USD/INR = 83.50 means 1 US Dollar = Rs 83.50.
Types of Exchange Rate Quotations
Direct Quotation
- Home currency per unit of foreign currency
- Example (in India): 1 USD = Rs 83.50
- Used in India for most currencies
Indirect Quotation
- Foreign currency per unit of home currency
- Example: Rs 1 = USD 0.01198
- Historically used in India (London system), now switched to direct quotation
Key Rule: In direct quotation, a higher rate means the home currency has depreciated.
Types of Exchange Rates
Based on Settlement Date
| Type | Settlement |
|---|---|
| Cash/Ready | Same day (today) |
| Tom (Tomorrow) | Next working day |
| Spot | Two working days after trade date (T+2) |
| Forward | Any date beyond spot (e.g., 1 month, 3 months) |
Tom Transaction: A deal settled on the next working day following the trade date.
Based on Transaction Type
| Rate | Used For |
|---|---|
| TT Buying Rate | Clean inward remittances (no document handling) |
| TT Selling Rate | Clean outward remittances |
| Bill Buying Rate | Purchase/discount of foreign currency bills |
| Bill Selling Rate | Sale of foreign currency against documents |
| TC Buying Rate | Purchase of traveller's cheques |
| TC Selling Rate | Sale of traveller's cheques |
Interbank Rate vs Merchant Rate
| Feature | Interbank Rate | Merchant Rate |
|---|---|---|
| Parties | Bank to bank | Bank to customer |
| Spread | Very narrow | Wider (includes bank's margin) |
| Volume | Large | Usually smaller |
| Quotation | Two-way (bid/ask) | One-way (buy or sell) |
How Banks Calculate Merchant Rates
Banks start with the interbank (spot) rate and add/deduct margins:
Buying Rates (Bank buys foreign currency from customer)
TT Buying Rate = Interbank Buying Rate - Exchange Margin
Bill Buying Rate = TT Buying Rate - Transit Interest (for the transit period of the bill)
Transit Interest accounts for the time the bank's funds are blocked while the foreign bill is in transit.
Selling Rates (Bank sells foreign currency to customer)
TT Selling Rate = Interbank Selling Rate + Exchange Margin
Bill Selling Rate = TT Selling Rate + Exchange Margin (additional for document handling)
Worked Examples
Example 1: Calculate TT Buying Rate
Given: Interbank spot rate USD/INR = 83.50/83.55, Exchange margin = 0.10%
TT Buying Rate = 83.50 - (83.50 x 0.10%) = 83.50 - 0.0835 = Rs 83.4165
(Rounded as per bank's policy)
Example 2: Calculate Bill Buying Rate
Given: TT Buying Rate = Rs 83.42, Transit period = 20 days, Interest rate = 8% p.a.
Transit Interest = 83.42 x 8/100 x 20/365 = Rs 0.3658
Bill Buying Rate = 83.42 - 0.3658 = Rs 83.0542
Example 3: Calculate TT Selling Rate
Given: Interbank spot rate USD/INR = 83.50/83.55, Exchange margin = 0.15%
TT Selling Rate = 83.55 + (83.55 x 0.15%) = 83.55 + 0.1253 = Rs 83.6753
Example 4: Forward Premium/Discount
Given: Spot rate = 83.50, 3-month forward rate = 84.20
Forward Premium = 84.20 - 83.50 = 0.70
Premium % (annualised) = (0.70/83.50) x (12/3) x 100 = 3.35% p.a.
Forward Premium and Discount
| Condition | Term |
|---|---|
| Forward rate > Spot rate | Forward Premium (foreign currency is at premium) |
| Forward rate < Spot rate | Forward Discount |
| Forward rate = Spot rate | At Par |
Annualised Premium/Discount Formula:
Premium/Discount % = [(Forward Rate - Spot Rate) / Spot Rate] x (12 / n) x 100
where n = number of months of the forward contract
Factors Affecting Exchange Rates
| Factor | Effect on INR |
|---|---|
| Higher inflation in India vs US | INR depreciates |
| Higher interest rates in India | INR may appreciate (capital inflows) |
| Current account deficit | INR depreciates |
| FII/FPI inflows | INR appreciates |
| RBI intervention (selling USD) | INR appreciates |
| Political instability | INR depreciates |
Interest Rate Parity (IRP)
The relationship between spot rate, forward rate, and interest rate differentials:
Forward Rate / Spot Rate = (1 + Interest Rate Home) / (1 + Interest Rate Foreign)
If India's interest rate is higher than the US rate, the INR is expected to depreciate (trade at a forward discount vs USD).
Purchasing Power Parity (PPP)
Exchange rates adjust to equalise the purchasing power of currencies:
Expected Spot Rate = Current Spot Rate x (1 + Inflation Home) / (1 + Inflation Foreign)
FEDAI Rules
The Foreign Exchange Dealers' Association of India (FEDAI) sets guidelines for forex transactions:
- Standardises exchange rate quotation practices
- Fixes rules for calculating value dates
- Prescribes guidelines for forward contracts
- Sets norms for interbank forex transactions
- Defines merchant rate calculation methodology
Key Points to Remember
- Direct quotation: Home currency per unit of foreign currency (used in India)
- Tom transaction: Settled on the next working day after trade date
- Spot transaction: Settled T+2 (two working days after trade)
- Forward premium: When forward rate is higher than spot rate
- TT Buying Rate = Interbank Rate minus margin
- Bill Buying Rate = TT Buying Rate minus transit interest
- TT Selling Rate = Interbank Rate plus margin
- FEDAI governs forex dealing practices in India
- Annualised premium formula: [(Forward - Spot) / Spot] x (12/n) x 100
- Higher domestic inflation leads to currency depreciation
- Interest Rate Parity links forward rates to interest rate differentials
- Banks earn profit from the bid-ask spread between buying and selling rates