(a) Explain the purchase and sate of foreign exchange. (b) Define and distinguish between direct and indirect quotation. (c) Explain “spread” with reference to a two-way market quote. (d) Explain the maxims; Buy High, Sell Low; Buy Low, Sell High.
(a) Purchase and sale of foreign exchange. For a bank in Bombay, the foreign exchange—be it pound-sterling, US dollar, Deutsche mark or Japanese yen—is the commodity in which it deals. As a dealer it undertakes to purchase as well as to sell the commodity of its trade. In a purchase transaction the bank acquires foreign currency and pays the customer in Indian rupees (home currency).
Examples of purchase transactions are: encashment of travelers cheques, purchase of cheques drawn on a foreign center, purchase of export bills, etc. In a sale transaction the bank parts with foreign currency and receives from the customer home currency.
Examples of sale transactions are: issue of foreign demand drafts, realization of an import bill, issue of travelers cheques, etc.
(b) Direct and indirect rates. The bank may quote the rate of exchange in either of the following ways:
(i) £ 1 = Rs. 45.00 — 45.50 ; or
(ii) Rs. 100 = £ 2.1978 – 2.2222.
In method (i) the rate of exchange is expressed for a fixed unit of foreign currency. The difference in the rate is expressed by a variation in the home currency, viz., rupee. Such a method where the unit of foreign currency is kept constant and price variation is reflected in the units of home currency is known as `direct’ or ‘home currency’ quotation. In method
(ii) the rate of exchange is expressed for a fixed unit of home currency. The difference in the rate is expressed by a variation in the foreign currency, viz., pound-sterling. Such a method, where the unit of home currency is kept constant and price variation is reflected in the unit of foreign currency is known as `indirect’ or ‘foreign currency’ quotation. Direct quotation is adopted in India with effect from 2nd August, 1993.
(c) Two-way quotation or bid and offer rates. In foreign exchange transactions the exchange quotation will have two rates—one at which the bank is willing to boy and the other at which it is willing to sell. This could be observed from the example in (b) above.
The rates at which the bank is willing to h known as the ‘bid’ rate and the buying to sell is known as rate. Of these two rates, the roe at which it is willing and selling rates are determined individually on the principle enunciated in (d) below (if) Buy High, Sell Low. Under indirect quotation pound-starling was quoted as:
Rs. 100 2.1978 – 2.2222. For a fixed sum of Rs. 100, the bank would like to acquire more of foreign currency while purchasing from the customer. For the same amount of Rs. 100, while selling, it would like to part with less of foreign currency. Therefore, in above quotation, the buying rate is £2.2222 and the selling rate is £2.1978. This principle is summed up in the maxim: ‘Buy High, Sell Low’. Buy Low, Sell High. Under direct quotation the rate for pound-sterling was quoted as: £ 1 Rs. 45.00 — 45.50. The bank buys foreign currency at a lesser price and sells it at a higher price. Therefore in the above quotation, the buying rate is Rs. 45.00 a; selling price is Rs. 45.50 per pound-sterling. This principle is stated in the form of a maxim: ‘Buy Low, Sell High‘.