Introduction to Currency Markets — from barter to the 24-hour forex market

Where this chapter sits

Chapter 1 carries 10% of the NISM-Series-I: Currency Derivatives paper. It is the vocabulary chapter — get base currency, two-way quotes and appreciation/depreciation right here, and every later chapter becomes easier.

Three things dominate: which currency is the base, how to read a bid/offer quote, and how to compute a cross rate.

1.1 How we got here

Initially, the trading of goods and services was by barter system wherein goods were exchanged for each other.

The workbook's own example is a good one: how does a dairy farmer exchange his cattle for few litres of edible oil or one kilogram of salt? The farmer has no way to divide the cattle!

Barter had three problems: non-divisibility of certain goods, cost in transporting such goods for trading and difficulty in valuing of services.

So money was invented. People tried various commodities as the medium of exchange ranging from food items to metals. Gradually metals became more prominent medium of exchange because of their ease of transportation, divisibility, certainty of quality and universal acceptance.

Then paper. People would deposit gold/ silver coins with bank and get a paper promising that value of that paper at any point of time would be equal to certain number of gold coins. This system of book entry of coins against paper was the start of paper currency.

And then foreign exchange. Each country has its own "brand" alongside its flag. When money is branded, it is called "currency". Whenever there is a cross-border trade, there is need to exchange one brand of money for another, and this exchange of two currencies is called "foreign exchange" or simply "forex" (FX).

The gold standard

The documented history suggests that at some time in 1870 countries agreed to value their currencies against value of currency of other country using gold as the benchmark for valuation. As per this process, central banks issue paper currency and hold equivalent amount of gold in their reserve.

The workbook's illustration: if one unit of gold is valued at Indian Rupees (INR) 10,000 and US dollar (USD) 500 than the exchange rate of INR versus USD would be 1 USD = INR 20.

Why it ended: with further growth in international trade, changing political situations (world wars, civil wars, etc.) and situations of deficit/ surplus on trade account forced countries to shift from gold standard to floating exchange rates.

Britain stopped using the gold standard in 1931 and the U.S. followed suit in 1933 and abandoned the remnants of the system in 1973.

What replaced it: fiat money is a government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it.

And the name explains itself — a term to describe currency that is used because of a government's order, or fiat, that the currency must be accepted as a means of payment. In the U.S., for instance, the US dollar is fiat money, and for India, it is the Indian rupee.

The gold standard is not currently used by any government.

Bretton Woods, 1944–1971

During 1944-1971, countries adopted a system called Bretton Woods System. This system was a blend of gold standard system and floating rate system.

How it worked: all currencies were pegged to USD at a fixed rate and USD value was pegged to gold. The US guaranteed to other central banks that they could convert their currency into USD at any time and USD value was pegged to value of gold.

With a band: countries also agreed to maintain the exchange rate in the range of plus or minus 1% of the fixed parity with US dollar.

Its legacy: with adoption of this system, USD became the dominant currency of the world. And the two institutions it created, i.e., the International Monetary Fund and the World Bank, played an important part in helping to rebuild Europe in the aftermath of World War II.

By 1973 the Bretton Woods System had collapsed. Countries were then free to choose any exchange arrangement for their currency, except pegging its value to the price of gold.

And that is when the forex market as we know it was born: the forex market therefore came into prominence when the world went off the gold standard. This is because during the gold standard, there were no exchange rates to determine!

The four regimes to know

Free float / clean float — a clean float, also known as a pure exchange rate, occurs when the value of a currency, or its exchange rate, is determined purely by supply and demand in the market.

Managed float / dirty float — which occurs when government rules or laws affect the pricing of currency. It is an exchange rate regime in which the exchange rate is neither entirely free (or floating) nor fixed. For example, a central bank might let its currency float between an upper and lower price boundary. If the price moves beyond these limits, the central bank may buy or sell large lots of currency in an attempt to rein in the price.

Pegged — the value of a currency is pegged to another currency or a basket of currencies. The benefit of a pegged currency is that it creates an environment of stability for foreign investors... However, it is difficult to maintain the peg in the long run.

Who does what: developed countries gradually moved to a market determined exchange rate (For e.g. USD, EUR, JPY etc.) and developing countries adopted either a system of pegged currency or a system of managed exchange rates.

1.2 The major currencies

Currency quotations use the abbreviations for currencies that are prescribed by the International Organization for Standardization (ISO) in standard ISO 4217. ISO currency codes are the three-letter alphabetic codes.

The Majors: Euro (EUR), US Dollar (USD), Japanese Yen (JPY), Pound Sterling (GBP), Australian Dollar (AUD), Canadian Dollar (CAD), and the Swiss Franc (CHF). These currencies follow free floating method of valuation.

The most active pairs: EURUSD, USDJPY, GBPUSD, AUDUSD, USDCAD, USDCNY and USDCHF.

Share of global daily turnover by pair (BIS, April 2022):

Minors and exotics. Currency pairs that are not associated with the U.S. dollar are referred to as minor currencies or crosses. These are usually derived from major non-USD currencies like EUR, GBP, and JPY. These pairs have slightly wider spreads and are not as liquid as the majors. Examples: EUR/GBP, EUR/JPY, and EUR/CHF.

Exotic Pairs stand out from these pairs because they contain a major currency (usually USD) and a currency from a developing or emerging market — USD/TRY (U.S. dollar/Turkish Lira), USD/SEK (US Dollar/Swedish Krona), EUR/TRY (Euro/Turkish Lira).

The currencies one by one

US Dollar (USD) — the home denomination of the world's largest economy, the United States. U.S. banknotes are issued in the form of Federal Reserve Notes, popularly called greenbacks due to their predominantly green color. Policy is run by the Federal Reserve System... founded in 1913 under the Federal Reserve Act.

Its five roles: "investment" currency in many capital markets, "reserve" currency held by many central banks, "transaction" currency in many international commodity markets, "invoice" currency in many contracts, and "intervention" currency employed by monetary authorities in market operations to influence their own exchange rates.

And a sixth — the vehicle role: for most pairs of currencies, the market practice is to trade each of the two currencies against a common third currency as a vehicle, rather than to trade the two currencies directly against each other.

Euro (EUR) — the official currency of 20 of the 27 member states of the European Union, and the second-largest and second-most traded currency in the international markets... after the United States dollar. Managed by the Frankfurt-based European Central Bank (ECB) and the Eurosystem (composed of the central banks of the eurozone countries).

Japanese Yen (JPY) — the third most traded currency in the world. It is widely used as a third reserve currency after the US dollar and the Euro and is preferred as a funding currency for "carry trades" by hedge funds.

British Pound (GBP) — until the end of World War II, the Pound Sterling was the currency of reference. The pound is nicknamed the 'cable'. This nickname is derived from the telegrams used to update the GBPUSD rates across the Atlantic. It is the fourth most-traded currency and the fourth most-held reserve currency in global reserves.

Swiss Franc (CHF) — considered a safe-haven currency. Given the stability of the Swiss government and its financial system, the Swiss franc usually faces a strong upward pressure stemming from increased foreign demand. It is also a popular funding currency along with the Japanese Yen.

Indian Rupee (INR) — the official currency of India. The rupee is subdivided into 100 paise. The issuance of the currency is controlled by the Reserve Bank of India... on the basis of the Reserve Bank of India Act, 1934.

Its regime, precisely stated: the Indian rupee has a market-determined exchange rate. However, the Reserve Bank of India trades actively in the USD/INR currency market to impact effective exchange rates. Thus, the currency regime in place for the Indian rupee with respect to the US dollar is a de facto controlled exchange rate. This is sometimes called a "managed float".

And a distinction from China: unlike China, India has not followed a policy of pegging the INR to a specific foreign currency at a particular exchange rate. RBI intervention in currency markets is solely to ensure low volatility in exchange rates, and not to influence the rate (or direction) of the Indian rupee.

Share of each currency in global daily turnover (BIS, April 2022): USD 88.4 · EURO 30.5 · JPY 16.7 · GBP 12.9 · INR 1.6 · Others 49.8 · TOTAL 200.

Why the total is 200, not 100: as two currencies are involved in each transaction, the sum of shares in individual currencies will total to 200%.

The international market

Foreign Exchange Market (Forex) is an inter-bank market that took shape in 1971 when global trade shifted from fixed exchange rates to floating rate regimes.

It never closes: for the currency market, the concept of a 24-hour market has become a reality. In financial centers around the world, business hours overlap; as some centers close, others open and begin to trade. For example, UK and Europe open during the afternoon (as per India time) followed by US, Australia and Japan and then India. The market is most active when both US and Europe are open.

But activity is uneven: in the New York market, nearly two-thirds of the day's activity typically takes place in the morning hours. Activity normally becomes very slow in New York in the mid-to late afternoon, after European markets have closed and before the Tokyo, Hong Kong, and Singapore markets have opened.

And traders behave accordingly: market participants often will respond less aggressively to an exchange rate development that occurs at a relatively inactive time of day and will wait to see whether the development is confirmed when the major markets open.

Its structure: the Forex market is a worldwide decentralized over-the-counter financial market for the trading of currencies.

Its size: as per the Triennial Central Bank Survey... in 2022, the average daily turnover of OTC foreign exchange is approximately USD 7.5 trillion. Growth of FX derivatives trading, especially in FX swaps, outpaced that of spot trading.

FX swaps are the largest single instrument — bigger than spot.

And arbitrage is thin: at any moment, the exchange rates of major currencies tend to be virtually identical in all the financial centers where there is active trading, leaving very little scope of arbitrage opportunities.

1.3 The mechanics

Currency pairs, base and quotation

In the currency market, while initiating a trade you buy one currency and sell another currency. Therefore, the same currency will have a very different value against every other currency.

The two currencies are called "base currency" (BC) and "quoting currency" (QC). The BC is the currency that is priced, and its amount is fixed generally at one unit. The other currency is the QC, which prices the BC, and its amount varies as the price of BC varies in the market.

The order is fixed: the standard practice is to write the BC code first followed by the QC code.

So in USDINR, USD is the base currency and INR is the quoted currency; and what is quoted in the market is the price of one USD expressed in INR.

And it matters which way round you write it: if you want the price of INR expressed in USD, then you must specify the currency pair as INRUSD.

Two examples from the workbook: if a dealer quotes a price of USDINR as 75, it means that one unit of USD has a value of 75 INR. Similarly, GBPUSD = 1.34 means that one unit of GBP is valued at 1.34 USD.

Note what changed: in case of USDINR, USD is base currency and INR is quotation currency while in case of GBPUSD, USD is quotation currency and GBP is base currency.

The market convention: in the interbank market, USD is the universal base currency except when it is quoted against Euro (EUR), Sterling Pound (GBP), Australian Dollar (AUD).

Direct and indirect quotes. In a direct quote, the foreign currency is the base currency, while the local currency is the quote currency. An indirect quote is just the opposite: the domestic currency is the base currency, and the foreign currency is the quote currency. And most countries use direct quotes.

The two segments of the Indian market

The foreign exchange market in India may be broadly divided into two segments. One segment is termed as the "interbank" market and the other is known as "merchant/retail" market.

The participants in the interbank segment are banks holding Authorised Dealer (AD) licenses under the Foreign Exchange Management Act (FEMA), 1999. Transactions run through trading platforms provide by Clearing Corporation of India Limited (CCIL), Refinitiv (formerly Thomson Reuters) etc. before being settled by CCIL (for Cash, Tom, Spot and Forward USD-INR transactions) through a process of multilateral netting.

The interbank market is where the volume is: these transactions are generally of very high volume and make up for the bulk of the global forex market volume. The retail forex market, on the other hand, has a large number of traders. The trading volume is, however, less than the interbank market as the value per transaction is low.

Market making — the mechanism of quoting price for both buying and selling is called market making.

The workbook's own analogy is worth keeping: your regular vegetable vendor will quote prices only for selling vegetables but not prices for buying them. While in a wholesale market, the vegetable wholesaler will not only quote prices for buying vegetables from the farmer but also quote prices for selling veggies to the vegetable retailer. Thus, the wholesaler is a market maker as he is quoting two-way prices.

And in the merchant segment: in a majority of the "merchant" markets, merchants are price-takers and banks are price-makers. A few large merchants or corporates may ask banks to quote two-way prices.

What retail customers can use: they can do so over the phone with an AD Bank or through proprietary electronic dealing platforms of individual banks and Multi-Bank Portals (MBPs). And RBI in 2019 has introduced an electronic trading platform for buying/selling foreign exchange by retail customers of banks. The platform, FX-Retail, was rolled out by the Clearing Corporation of India Limited (CCIL) on August 05, 2019.

Where each product trades: forex trading in India typically takes place over-the-counter (including Electronic trading platform) for spot, forward and swaps... futures are traded on exchanges, i.e., National Stock Exchange (NSE), Bombay Stock Exchange (BSE) and Metropolitan Stock Exchange of India Ltd. (MSEI). Options are traded both OTC as well as on Exchanges.

Two-way quotes

In a two-way quote, the price quoted for buying is called bid price and the price quoted for selling is called offer or ask price.

The single most important sentence in this chapter: these prices are always from the perspective of the market maker and not from the perspective of the price taker.

The worked example: suppose a bank quotes USDINR spot price as 75.0550/75.0600 to a merchant. In this quote, 75.0550 is the bid price and 75.0600 is the offer price or ask price. This quote means that the bank is willing to buy one unit of USD for a price of INR 75.0550 and is willing to sell one unit of USD for INR 75.0600.

So from the customer's side: a merchant interested in buying one unit of USD will get it for a price of INR 75.06 i.e. the price at which bank is willing to sell, and a merchant interested in selling one unit of USD will receive Rs. 75.055 i.e. the price at which the bank is willing to buy.

You buy at the offer and sell at the bid — always the worse of the two for you.

The spread — the difference between the bid and offer is called the "spread"... The spread is an important parameter to note while assessing market liquidity, efficiency of the market maker and the market direction. Clearly, a narrow spread indicates higher liquidity and higher efficiency of the market maker.

Two patterns: in the USDINR spot market, the spreads are wide at the time of opening and gradually start narrowing as the market discovers the price. And for a USD 100 mn transaction the spread is likely to be higher when compared to the spread for USD 1 mn transaction.

The quoting norms:

1. The bid price (lower price) is quoted first followed by offer price (higher price)

2. The offer price is generally quoted in abbreviated form. In case the currency pair is quoted up to four decimal places, then the offer price is quoted in terms of last two decimal places and if the currency pair is quoted in two decimal places, then offer price is quoted in terms of two decimal places.

Appreciation and depreciation

Whenever the base currency buys more of the quotation currency, the base currency has strengthened / appreciated, and the quotation currency has weakened / depreciated.

For example, if USDINR has moved from 82 to 82.25, the USD has appreciated against INR and the INR has depreciated against USD.

The two rules:

a. Base currency appreciates when it can buy more units of quotation currency. For example, USD INR moves from 82 to 83 it means the base currency (USD) strengthens and the quotation currency (INR) weakens.

b. Quotation currency strengthens when the base currency buys lesser units of quotation currency. For example, USD INR moves from 83 to 82 it means the base currency (USD) weakens and the quotation currency (INR) strengthens.

What buying a pair means: this translates to you being bullish on the base currency and bearish on the quotation currency at the same time. And selling it means you anticipate the base currency to buy lesser amount of quotation currency... bearish on base currency and bullish on the quotation currency.

And a caution: appreciation and depreciation of one currency is always in terms of other currency. Hence, it is possible that USD can appreciate against INR, however at the same time USD may depreciate against EUR.

Market timing

In India, for OTC market FEDAI (Foreign Exchange Dealers' Association of India) has stipulated market timings for inter-bank INR forex transactions. The normal market hours for FCY/INR transactions in Inter-bank forex market as well as client transactions in India is from 9.00 a.m. to 5.00 p.m. IST on all working days.

The rules around those hours:

A. Authorised dealers may undertake customer... and inter-bank transactions on all working days beyond normal market hours.

C. However, value Cash transactions may be undertaken only up to 5.00 pm IST, except in case of individual persons (including joint account or proprietary firm).

D. Transactions, including value cash transactions, for individual persons... can be undertaken even on Saturdays, Sundays and holidays as per a bank's internal policy.

F. Spot date Roll over for FCY/INR transactions will take place at 12.00 midnight IST.

G. For the purpose of Foreign Exchange business, Saturday will not be treated as a working day except for individual transactions.

H. NOOP Limit is maintained all the time [including transactions executed from EOD to 9.00 am IST (market opening time) next working day].

The exposure limits are dual: Net Overnight Open Position Limit (NOOPL) for calculation of capital charge on forex risk and Limit for positions involving Rupee as one of the currencies (NOP-INR) for exchange rate management.

And a hard cap: NOOP limit may be fixed by the boards of the respective banks and communicated to the Reserve Bank of India immediately. However, such limits should not exceed 25 percent of the total capital (Tier I and Tier II capital) of the bank.

For Indian banks the limit is aggregate — for banks incorporated in India, the exposure limits fixed by the Board should be the aggregate for all branches including their overseas branches and Off-shore Banking Units. For foreign banks, the limits will cover only their branches in India.

Base rates and card rates

Base rate is the rate derived from ongoing market rate, based on which buying / selling rates are quoted for merchant transactions. Normally, the interbank rates are for spot deliveries are considered as base rate.

Card rates: banks also follow the practice of fixing "card rates" for the various forex pairs at the beginning of the day at which purchases and sales from/to retail customers would be made regardless of the intraday movement of the currency.

But not rigidly: on the days of high volatility, banks revise the card rate multiple times during the day. The difference between IBR and card rate is high to cover the risk of price fluctuation. Card rates could vary significantly from bank to bank.

And a fairness expectation: member banks are free to determine their own charges... keeping in view the advice of RBI that such charges are not to be out of line with the average cost of providing services. Banks should take care to ensure that customers with a low volume of activities are not penalised.

Price discovery

Forex market in India is predominantly a wholesale market, dominated by banks, forex brokers and corporate clients. Customers are priced off-market by banks.

Where interbank price discovery happens: major trading venues for interbank spot market are Refinitiv D2 and FX Clear, while forex swaps are largely transacted outside platform on a bilateral basis.

A pattern in volumes: the spot trading market is well distributed through the day, while in case of forex forwards, volumes typically increase gradually during the day, with the last two hours having relatively higher volumes.

A structural gap: domestic markets are closed during important currency trading sessions such as New York time and Tokyo time. Hence, any major domestic or international event or data release during hours when the Indian markets are closed, are not priced in by the residents and this may impact the opening rates of the Rupee. In extreme cases, it may manifest in a gap-up or gap-down at market opening.

And a growing offshore influence: Non-Delivery Forward (NDF) volumes especially for USDINR pair have increased in the recent period, they have begun to play an important role in both price discovery and driving volatility, particularly during periods of heightened uncertainty. An NDF is a cash-settled, and usually short-term, currency forward contract. The notional amount is never exchanged, hence the name "non-deliverable."

The FBIL reference rate

The reference rates for USD/INR and other major currencies are computed and disseminated by the Financial Benchmarks India Private Limited (FBIL). FBIL is recognised by Reserve bank of India as an independent Benchmark administrator and has assumed the responsibility... with effect from July 10, 2018.

Which rates: the FBIL reference rate is calculated for USD/INR, GBP/INR, EUR/INR and JPY/INR — published... on a daily basis on all Mumbai business days at around 13.30 hours.

The method for USD/INR: computed based on the data in respect of the actual spot US dollar/Indian rupee transactions taking place on electronic platforms during the one-hour time window from 11.30 Hours to 12.30 Hours on each business day in Mumbai. Data comes from Refinitiv (formerly Thomson Reuters) and CCIL platforms.

A 15-minute random window is selected between 11.30 and 12.30 hours for the computation of USD/INR reference rate.

The threshold: the threshold criteria of ten transactions with aggregate amount of USD 25 million are required to be met for calculating the reference rate.

Outliers are removed: a +/- 3 Standard Deviation (SD) rule is applied to the transaction data... to remove the outliers. The Reference Rate is set equal to the volume-weighted average of the surviving transactions.

If the window is too thin: a second random time-period of 15 minutes is generated. This process is repeated up to a maximum of 5 times. If all five fail, the transactions data pertaining to the whole one-hour window from 11.30 Hours to 12.30 Hours are taken into account.

And a last resort: in case of systems/network failures, if adequate transactions data is still not available, the reference rate is computed using the polled submissions from a panel of Category-I authorised dealer banks selected on the basis of their USD/INR inter-bank market turnover, submitted over a 15-minute time window around 13.00 Hours, with a minimum of five quotes... required for calculation.

The cross rates — for calculation of EUR/INR, GBP/INR and JPY/INR reference rates, the ruling spot cross currency rates for EUR/USD, GBP/USD and USD/JPY are obtained from any electronic platform, taken from the same randomly selected time-period of 15 minutes, and the mean of the closing prices, so obtained, is crossed with the USD/INR reference rate.

Units and decimals: the reference rates in respect of EURO and GBP are published for 1 unit of Euro and GBP and the reference rate in respect of JPY is for 100 units of JPY. EUR/INR and GBP/INR Reference rates are published up to 4 decimal places while the JPY/INR reference rate is published up to 2 decimal places. The USD/INR reference rate is published up to 4 decimal places.

Forward Premia Curve — FBIL announces the benchmark rates for US Dollar - Indian Rupee Forward Premia for Overnight and from 1 month to 12 months tenor on a daily basis, determined based on the USD/INR transactions data reported up to 3 PM on the CCIL platform. And for calculation of Overnight rate, the Cash-Tom transactions up to 12 noon are used.

Value dates

The trade date is the day on which both parties agree to buy and sell. The settlement date/value date is the day on which currencies are actually transferred between the buyer and seller.

The four value dates:

Spot needs care: the correct definition of spot value date is settlement on the second business day, subject to both centers being open on that day. If one of them is closed, then the settlement will be on the next business day (which could be third or fourth, etc., after the trade date) on which both centers are simultaneously open.

Cash and tom are derived, not traded: the price at which settlement takes before the spot date is a derived price from the spot price and is not a traded price.

Forwards are standardized into 1-month, 2-month, etc. after spot value date. In one, both parties enter into a contract on a given day and lock in a fixed rate on a specific future date... the terms of the purchase (buy or sell) are agreed upfront (trade execution date), but actual exchange take place on a date in the future (maturity date). These are known as outright forward contracts (OFTs).

And note the settlement difference that runs through the whole exam: the settlement of forward contracts is mainly physical, i.e. with exchange of actual currencies. This is unlike the currency futures market, where prices are available for month-end maturity contract and the settlement is always on net settlement basis.

1.4 Cross rates

Prices for some currency pairs are not directly available and are rather derived by crossing the prices of underlying currency pairs. In market parlance, the price of the currency pair for which direct quotes are not available is called as the 'cross rate'.

The workbook's approach is deliberately plain: although there are methods like chain rule, Left Hand-Right hand etc. prescribed in various books, we would explain the derivation of cross rate using simple commercial logic.

The one thing to hold on to: it is important to identify this FX conversion path of selling one currency and buying another to calculate the cross rate.

EURINR

The underlying currency pairs for deriving prices of EURINR are EURUSD and USDINR.

Given EURUSD: 1.1125 / 1.1150 and USDINR: 75.64 / 75.65.

To buy 1 EUR: you need to sell INR to buy USD; and further sell the USD received to buy EUR.

To buy 1 unit of USD, the applicable price is 75.65 INR (offer side)... The price for buying 1 unit of EUR is 1.1150 USD (offer side). Therefore, price of buying 1.1150 units of USD would be 1.1150 x 75.65 INR i.e. 84.3498 INR.

Selling side: the price comes to 84.1495 (1.1125 x 75.64).

Therefore, the cross rate for EURINR would be 84.1495 / 84.3498.

Both sides multiply, and each side uses the matching side of both underlying quotes — offer × offer for buying, bid × bid for selling.

GBPINR

The underlying currency pairs are GBPUSD and USDINR. Assume GBPUSD price as 1.3300 / 1.3325 and USDINR as 75.64 / 75.65, the price for GBPINR works out to be 100.6012 / 100.8036.

Check: 1.3300 × 75.64 = 100.6012 and 1.3325 × 75.65 = 100.8036. Same structure as EURINR.

JPYINR

For JPYINR, the market convention is to quote price of 100 JPY in terms of INR.

And the arithmetic differs: in case of GBPINR and USDINR computation, USD is base currency for one currency pair and quote currency for other currency pair. However, in case of JPYINR, USD is base currency for both the currency pairs.

Given USDJPY: 115.08 / 115.09 and USDINR: 75.64 / 75.65.

To buy 1 unit of USD, the applicable price is 75.65 INR (offer side)... The price for selling one unit of USD is 115.08 (bid side). Therefore, you get 115.08 JPY by spending 75.65 INR. Thus, price of buying 1 JPY is 75.65/115.08 i.e. 0.6574 INR or in other words price of buying 100 JPY is 65.74 INR.

And selling: price of selling 1 JPY is 75.64/115.09 i.e. 0.6572 or in other words price of selling 100 JPY is 65.72 INR.

Thus, price of JPYINR (for 100 JPY) would be 65.72 / 65.74 INR.

Note the crossed sides: buying uses 75.65 ÷ 115.08 — the USDINR offer over the USDJPY bid. When both pairs share USD as base, you divide and you cross the sides.

And the method works backwards too: using EURINR and USDINR rate, EURUSD rate could be calculated.

1.5–1.6 What moves currencies

The price of one currency in terms of another is linked to the relative economic strength of the country in the long run, in the same way as the equity price is linked to the fundamental strength of a company. In the short run, factors like demand supply mismatch, global risk appetite, important political events etc. may determine the currency price.

For the rupee specifically: the value of INR against USD is a function of factors local to India like gross domestic product (GDP) growth rate, balance of payment situation, deficit situation, inflation, interest rate scenario, policies related to inflow and outflow of foreign capital. It is also a function of factors like prices of crude oil, value of USD against other currency pairs and the geopolitical situation.

Everything acts at once: all the factors are at work all the time and therefore some factors may act towards strengthening of the currency and others may act towards weakening. It becomes important to identify the dominating factors at any point in time.

And a warning against reading indicators mechanically: it cannot be said with certainty that an indicator showing robust economic health of the country would mean strengthening of the currency of that country.

The workbook's own counter-example: during global financial crisis of 2008 and 2009, the USD strengthened against all major currencies like EUR, GBP and JPY. This was despite the US running a record high fiscal deficit and its economy not doing well.

The indicators

GDP — represents the total market value of all final goods and services produced in a country during a given year. A GDP growth rate higher than expected may mean relative strengthening of the currency of that country, assuming everything else remaining the same.

Industrial Production (IIP) — shows the changes in the production in the industrial sector of an economy in a given period of time, in comparison with a fixed reference point in the past. In India, the fixed reference point is 2011-12. A healthy IIP number indicates industrial growth, which could result in relative strengthening of the currency.

Consumer Price Index (CPI) — a statistical time-series measure of the weighted average of prices of a specified set of goods and services purchased by consumers... A rising CPI means rising prices for goods and services and is an early indicator of inflation.

Its effect is two-sided: if rising CPI means a likely increase in interest rates by the central bank, the currency may strengthen in the short run but may start weakening in the long run as rising inflation and rising interest rates start hurting the growth of the economy.

And in India, CPI is the anchor: Reserve Bank of India has started using CPI as the main indicator for measuring inflation.

Real interest rate — if the 10-year G-Sec has a yield of 6.5% and if the inflation is at an average of 2% then the real interest rate is 4.5%.

Normally, there is a positive relationship between the real interest rates and the value of the INR. That is why it is seen that whenever the RBI hikes rates, the INR actually sees an appreciation in value.

With a flow explanation: when real interest rates are high, we see more flows into debt from Foreign Portfolio Investors (FPIs). As more dollars flow in, the additional supply of dollars in the market tends to make the INR stronger.

Current account and trade deficit — the excess of imports over exports i.e. trade deficit, is a key factor to track... In general, a narrowing of the trade deficit is a positive for the domestic currency.

But context matters: during periods of risk aversion, any development resulting in widening of the current account deficit results in weakening of INR. However, during periods of higher risk appetite, the market tends to ignore small changes in the current account deficit.

Non-farm payrolls (NFP) — the number of jobs added or lost in the economy over the last month, not including jobs relating to the farming industry, government jobs, household jobs and employees of non-profit organization. Released monthly by the Bureau of Labor Statistics, it is one of the most important indicators analyzed by market participants. A rising and positive number means that the economy is adding jobs, which is good for the currency.

Retail Sales — a coincident indicator and shows the strength of the consumer spending. The report for the US is published around 13th or 14th of each month by United States Census Bureau.

Central bank actions — the market also tracks minutes of the central bank meetings and the key policy decisions. Some of the important announcements... are their interest rate decisions, CRR (cash reserve ratio). And intervention in foreign exchange markets is a tool on which Emerging Market Economies (EME) central banks have extensively relied on over the past two decades.

A closing caution worth remembering all through this exam: it is noticed that not all indicators are important at a particular point in time. It is important to find out which indicators are getting most of the attention of the market at any given point in time.