Exchange Rates and Forex Business: CAIIB Paper 2 (Module A), Unit 1

Exchange Rates and Forex Business: CAIIB Paper 2 (Module A), Unit 1

Dear Bankers,
We all know that CAIIB exams are conducted by the Indian Institute of Banking and Finance (IIBF).  CAIIB is said to be one of the difficult courses to be cleared for the bankers. But we assure you that with the help of our “CAIIB study material”, you will definitely clear the CAIIB exam.
CAIIB exams are conducted twice in a year. Candidates should have completed JAIIB before appearing for CAIIB Exam. Here, we will provide detailed notes of every unit of the CAIIB Exam on the latest pattern of IIBF.
So, here we are providing “Unit 1 Exchange Rates and Forex Business of “Module A: International Banking” from “Paper 2: Bank Financial Management (BFM)”.

 Foreign Exchange – Definition and Markets

Foreign Exchange Management Act (FEMA), 1999, (Section 2) defines foreign exchange as:

Foreign Exchange means foreign currency, and includes:

  • All deposits, credits and balances payable in foreign currency, and any drafts, traveller’s cheques, letters of credit and bills of exchange, expressed or drawn in Indian currency and payable in any foreign currency,
  • Any instrument payable at the option of the drawee or holder, thereof or any other party thereto, either in Indian currency or in foreign currency, or partly in one and partly in the other.” Thus, broadly speaking, foreign exchange is all claims payable abroad, whether consisting of funds held in foreign currency with banks abroad or bills, checks payable abroad.

Foreign Exchange Markets

Foreign exchange markets comprise a large spectrum of market participants, which include individuals, business entities, commercial and investment banks, central banks, cross border investors, arbitrageurs and speculators across the globe, who buy or sell currencies for their needs.

The world currency market is a very large market, with a large number of participants. Major participants of FOREX markets are:

  • Central Banks – managing their forex reserves and using currency markets strives to reduce the volatility and smoothen out the value of their home currency.
  • Commercial Banks – offering exchange of currencies to their big and retail clients and hedging and investing their own assets and liabilities, as also on behalf of their clients, and also speculate on the exchange rate movements in the markets.
  • Investment Funds/Banks – moving funds from one country to another using exchange markets as a vehicle for investments as also hedging their investments in various countries/currencies.
  • FOREX Brokers – acting as middleman, between other participants, and at times taking positions on their books.
  • Corporations – moving funds between different countries and currencies for investment or trade transactions or even speculation in currency markets.

Thus, the characteristics of foreign exchange market can be listed as under:

  • a 24-hour market
  • an over the counter market as well exchange driven market
  • a global market with no barriers/no specific location
  • a market that supports large capital and trade flows
  • highly liquid markets
  • high fluctuations in currency rates. (every seconds)
  • settlements affected by time zone factor
  • markets affected by governmental policies and controls

 Factors Determining Exchange Rates

The quotations in the FOREX markets depend on the delivery type of the foreign currencies, i.e., exchange of streams of the two currencies being dealt with. The spot rates, being the base quotes in the FOREX markets are more dynamic and are effected by varied reasons, a few of which are fundamental and other technical. The main factors, which influence movement of exchange rates, can be summarized as under:

  • Fundamental Reasons

These include all those causes or events, which affect the basic economic and monetary policies of the concerned government. The causes normally affect the long-term exchange rates, while in the short-run, many of these are found ineffective.

In a long run, exchange rates of all currencies are linked to fundamentals, as given under:

  • Balance of payment – generally a surplus lead to a stronger home currency, while a deficit weakens the same.
  • Economic growth rate – a high growth leads to a rise in imports and a fall in the value of home currency, and vice versa.
  • Fiscal policy – an expansionary policy, e.g., lower taxes can lead to a higher economic growth.
  • Monetary policy – the way, a central bank attempts to influence and control interest and money supply can impact the value of currency of their country.
  • Interest rates – high domestic interest rates tend to attract overseas capital, and thus the currency appreciates in the short term. In the longer term, however, high interest rates slow the economy down, thereby weakening the currency.
  • Political issues – political stability is likely to lead the economic stability, and hence a steady currency, while political instability would have the opposite effect
  • Technical Reasons

Government controls can lead to an unrealistic value of a currency, resulting in violent movement in exchange rates. Freedom or restriction on capital movement can affect exchange rates to a larger extent. This is a phenomenon, which was seen in Indonesia, Thailand, Philippines, Korea, etc.

  • Speculation

Speculative forces can have a major effect on exchange rates. In an expectation that a currency will be devalued, the speculator will short sell the base currency (say $) for buying it back cheaper at a later date. This very act can lead to movements in the market, as the expectation for devaluation grows extends to other market participants as well.

 Exchange Rate Mechanism

Types and Calculation

  • Due to the vastness of the market, operating in different time zones, most of the FOREX deals are done on SPOT basis, meaning thereby that the delivery of the funds takes place on the second working day following the date of deal/contract. The rate at which such deals are done is known as SPOT rates.
  • Spot rates are the base rates for other FX rates. The date of delivery of funds on the date, on which the exchange of currencies actually takes place, is also referred to as “value date’ or ‘settlement date”. The delivery of FX deals can be settled in one or more of the following ways:

Ready or Cash

  • Settlement of funds takes place on the same day (date of deal), e.g., if the date of Ready/Cash deal is 3 October 2016 (Monday), settlement date will also be 3 October 2016.


  • Settlement of funds takes place on the next working day of the date of deal, e.g., if the date of TOM deal 3 October 2016 (Monday), settlement date would be 4 October 2016 (Tuesday, provided it is a working day for the markets dealing as well as where currency is to be settled). If Tuesday is a holiday, in either of the 2 countries, the settlement date will be next common working day in both the countries. Intervening Saturdays and Sundays will also postpone the settlement date to next working day.


  • Settlement of funds takes place on the second working day after/following the date of contract/deal, e.g., if the date of Spot deal is 3 October 2016 (Monday), settlement date will be 5 October, 2016. (Presuming all markets are working on 3, 4 and 5 October 2016). If not, it will the next working day in both the countries. Intervening Saturdays and Sundays will also postpone the settlement date to next working day.


  • Delivery of funds takes place on any day after Spot date, e.g., if the date of forward deal is 3 October 2016 (Monday), for value settlement date 30 October 2016 or 30 November 2016, it is a forward deal.

Cross Rate

When we deal in a market where rates for a particular currency pair are not directly available, the price for the said currency pair is then obtained indirectly with the help of cross rate mechanism. This can be explained with the following example:

Suppose, we intend to get a quote for Euro/INR and no one is prepared to quote Euro/INR directly in the market. We can work out a Euro/INR quote through Euro/USD and USD/INR quotes.

Euro/USD quote would be available in the international markets and USD/INR would be available in the domestic market. By crossing out USD in both the quotes, we can arrive at an effective Euro/ Rs. Quote.

This is the basis for working out cross rates. Cross rate mechanism is a possible solution for calculation of rates for currency pairs which are not actively traded in the market.

For example, we need to quote GBP against INR, but in India, usually GBP is not quoted directly, as such we need to take rates for USD/INR and GBP/USD to compute GBP/INR rate.

 If, USD/INR is 68.10/11, and GBP/USD is 1.2100/10, then, to GBP/INR rate, we need to cross (multiply) both the given rates, which would give us GBP/INR rate as Rs. 82.40/82.48.

Or say if USD/JPY is 116.50/60, the rate for Rupee/JPY would be Rs. 58.40/46 per 100 JPY (JPY being quoted per 100 units, due to their values).

Fixed vs. Floating Rates

  • The fixed exchange rate is the official rate set by the monetary authorities for currencies. It is usually pegged to one or more currencies. Under floating exchange rate, the value of the currency is decided by supply and demand factors for that particular currency.
  • In some cases, even fixed exchange rates are allowed to fluctuate between definite upper and lower bands, as fixed by the monetary authority of the country.

Bid and Offer Rates

  • The buying rates and selling rates are also referred to as bid and offer rates. In a USD/INR quote, of 68.10/11, the quoting bank is bidding for USD at 68.10 and is offering to sell the USD at 68.11. On the other hand, in a GBP/USD rate 1.2100/10, the quoting bank is willing to buy GBP at 1.2100 and willing to sell at 1.2110

Exchange Arithmetic – Theoretical Overview

  • All foreign exchange calculations have to be worked out with extreme care and accuracy and the decimal point has also to be correctly placed. Constant check is also required to minimize the risk of mistake, as the markets work on very thin margins. An error in one quote may erode earnings from several trades/transactions.

Chain Rule

  • It is used in attaining a comparison or ratio between two quantities linked together through another or other quantities and consists of a series of equations, commencing with a statement of the problem in the form of a query and continuing the equation in the form of a chain so that each equation must start in terms of the same currency as that which concluded the previous equation.

Per Cent and Per Mille

A percentage (%) is a proportion per hundred, e.g., 1% is one part in every hundred parts such as Rupee 1 per Rupees 100, while per mille means per thousand, e.g., 1 per mille is one part in every thousand, such as Rupee 1 per Rupees 1,000.

Value Date

  • This is the term used to define the date on which a payment of funds or an entry to an account becomes actually effective and/or subjected to interest, if any. In the case of payments on Telegraphic Transfers (TT) the value date is usually the same in both centres

Arbitrage in Exchange

  • Arbitrages consist of the simultaneous buying and selling of a commodity or currency in two or more markets to take advantage of temporary discrepancies in prices.

 Foreign Exchange Dealing Room Operations

  • The FOREX dealing room operations comprise functions of a service branch to meet the requirements of customers of other branches/divisions to buy or sell foreign currency, manage foreign currency assets and/or liabilities, fund and manage NOSTRO accounts as also undertake proprietary trading in currencies. It acts as a separate profit centre for the bank/institution.

Management and Control of a Dealing Room

  • Reserve Bank of India, has advised that the Board of Directors of banks should frame an appropriate policy and fix suitable limits for its FOREX dealing functions. The management of dealing room operations should focus on risk associated with foreign exchange dealing room operations, which arise due to complex nature of foreign exchange markets and the volatile nature of exchange rate movements.
  • The major risks associated with foreign exchange dealing operations, where the management needs to frame policies and keep a constant vigil, can be summarized as under.

RBI/FEDAI Guidelines

The Reserve BANK of India, being the central bank of the country and the custodian of nation’s foreign exchange reserves, has prescribed guidelines for authorized dealers, permitted by it, to deal in foreign exchange and handle foreign currency transactions. FEMA 1999, also prescribes rules for persons, Corporates, etc., in handling foreign currencies, as also transactions denominated therein.

The Reserve Bank of India issues Authorized Dealers’ (AD) licenses to banks and all-India financial institutions to undertake foreign exchange transactions in India. At present there are over 90 ADs, which include all public sector banks, foreign and a large number of private banks, a few all-India financial institutions and a few Scheduled cooperative banks.

The RBI also issues Money Changer licenses to a large number of established firms, companies, hotel, shops, etc., to deal in foreign currency notes, coins and traveller’s cheques, to facilitate encashment foreign currency for foreign tourists. Entities authorized to buy and sell foreign currency notes, coins and traveller’s cheques are called Full Fledged Money Changers (FFMCs) while those authorized only to buy are called Restricted Money Changers (RMCs).

Foreign Exchange Dealers Association of India, (FEDAI), on the other hand, is a non-profit making body, formed in 1958 with the approval of Reserve Bank of India, consisting of Authorized dealers as members. FEDAI prescribes guidelines and rules for market operations, merchant rates, quotations, delivery dates, holidays, interest on defaults, etc. In terms of RBI directives, all authorized dealers are members of FEDAI and it is mandatory for them to follow the guidelines/directives issued by FEDAI.

A few of the major FEDAI guidelines/rules can be summarized as under:

  • All export bills to be allowed standard transit period (NTP – normal transit period), as prescribed, for the purpose of allowing concessional interest rates and calculation of notional due dates.
  • Export bills drawn in foreign currency, purchased/discounted/negotiated, must be crystallized in rupee liability, in case of delay in realization of export bills. The same would be done at TT selling rate. The prescription of crystallization of export bills on the 30th day from the due date/notional date, has since been relaxed. Authorized Dealer Banks should formulate their own policy for crystallization of foreign currency liability into Rupee liability. The policy in this regard should transparently available to the customers.
  • Unpaid foreign currency import bills drawn under letters of credit shall be crystallized as per the stated policy of the Bank in this respect.
  • All forward contracts must be for a definite amount and period with specific delivery dates.
  • Option period can be specified by the customer, in case of forward contracts, but in any case, the delivery period under the contract shall not exceed beyond one month. All such contracts must state the start and end dates.
  • Cancellation of forward contracts – All contracts, which have matured and have not been picked up, shall be automatically cancelled on the THIRD working day, after the maturity date.
  • All cancellations shall be at bank’s opposite TT rates, TT selling rate for purchase contracts and TT buying rate for sale contracts.
  • In the event of delay in payment of interbank foreign currency funds, interest at 2% above the prime rate of the currency of the specified banks shall be paid by the defaulting bank.
  • In the event of delay in payment of rupee settlement funds, interest for delayed period at 2% above the NSE MIBOR ruling on each day shall be paid.
  • All currencies to be quoted as – per unit of foreign currency = INR, while JPY, Indonesian Rupiah & Kenyan Shilling are to be quoted as 100 units of foreign currency = INR.
  • FEDAI also prescribes code of conduct for FOREX dealers, as also guidelines with regard to dealings with FOREX brokers.

 Example 1

Inflow of USD 100,000.00 by TT for credit to your exporter’s account, being advance payment for exports (credit received in NOSTRO statement received from New York correspondent). What rate you will take to quote to the customer, if the market is 68.09/11?


It will be purchase of USD from customer for which USD will have to be sold in the market. Say when USD/INR is being quoted as 68.09/11, meaning that market buys USD at INR 68.09 and sells at INR) 68.11. We shall have to quote rate to the customer on the basis of market buying rate, i.e. 68.09 less margin, as applicable, to arrive at the IT Buying Rate applicable for the customer transaction.

Example 2

Retirement of import bill for GBP 100,000.00 by TT Margin 0.20%, ignore cash discount/premium, GBP/ USD 1.2175/85, USD/INR 68.14/15. Compute Rate for Customer


For retirement of import bill in GBP, we need to buy GBP, to buy GBP we need to give USD and to get USD, we need to buy USD against Rupee, i.e. sell Rupee.

At the given rates, GBP can be bought at 1.2185 USD, while USD can be bought at 68.15. The GBP/INR rate would be 83.0408 (1.2185X68.15), at which we can get GBP at market rates. Thus the interbank rate for the transaction can be taken as 83.0408.

Add Margin 0.20% 0.1660.

Rate would be 83.0408 +0.1660 = 83.2068 or say 83.2070 for effecting import payment. (Bill Selling Rate).

Example 3

On 15 September, a customer requests for booking of a forward contract for export bill of USD 150,000.00, to be realized in the month of December.

Given that USD/INR spot is 68.45/50 and forward premium is as under:

October: 18/19 paise

November: 30/32 paise

December: 41/43 paise

Margin to be charged 0.05 paise per USD.


For calculating rate for forward purchase contract, we need to take forward premium for November, the one that the market would pay, i.e. 30 paise. Spot rate as 68.45, getting forward interbank rate as 68.75 and deduct 0.05 paise as margin to arrive at 68.70 the customer forward rate for delivery of export proceeds during December, full month at the option of the customer (Forward TT Buying Rate). Forward margin for the period prior to the start of the delivery period would be passed on, as the customer has an option to deliver currency on the first day itself, i.e. 1st December.

CAIIB Online Mock test with Explanation

CAIIB Mock Link
CAIIB Paper-I (Advanced Bank ManagementOnline Mock
  • Unit wise Mock- 300+questions·
  • Cast Study Mock
  • Full length Mock 5- 500 Questions (Each Mock 100 Q)
  • Memory based Mock

Click here -Mock Link

Total- 1000+ Questions

CAIIB Paper-II (Bank Financial Management)Online Mock
  •  Unit wise Mock- 350+Questions·
  • Case Study Mock
  • Full length Mock 5- 500 Questions(Each Mock 100 Q)
  • Memory based Mock

Click Here- Mock Link

Total- 1000+ Questions

CAIIB/DBF Paper-3 (Retail Banking) Online Mock
  • Unit wise Mock-300Questions·
  • Full length Mock 3- 300 Questions(Each Mock 100 Q)
  • Memory based Mock

Click here-Mock Link

(600+ Questions)
  •  Approx (2700 +Questions) + Capsule PDF

Click here-Mock Link


CAIIB Combo (Paper 1+ Paper 2)
  • 2000 Questions+

Click here-Mock Link




Leave a Reply