Unit 8

Meaning and concept of foreign exchange service

Foreign exchange:

• The process or mechanism by which the currency of one country is converted into foreign
currency of another country and thereby involves in the international transfer of money.

• In banks when we talk about foreign exchange, we refer to general mechanism by which
bank convert currency of one country into that of another country.

• The term currency includes:

➢ Notes and coins
➢ Bank balances and deposits in foreign currency
Instruments which are capable of being used as currency:
➢ Bills of exchange
➢ Promissory note
➢ Letter of credit
➢ Travelers Cheque
➢ Draft
➢ Telegraphic transfer

Foreign exchange market

• The foreign exchange market is a market where foreign exchange transactions takes place.
• The foreign exchange market is a global decentralized or over-the-counter (OTC) market
for the trading of currencies.
• The foreign exchange market is over a counter (OTC) global marketplace that determines
the exchange rate for currencies around the world.
• This foreign exchange market is also known as Forex, FX, or even the currency market.
• The participants engaged in this market are able to buy, sell, exchange, and speculate on
the currencies.
• The foreign exchange market assists international trade and investment by enabling
currency conversion.
• These foreign exchange markets are consists of banks, forex dealers, commercial
companies, central banks, investment management firms, hedge funds, retail forex dealers,
and investors.
• The foreign exchange market is the mechanism by which participants engaged in:
➢ Transfer function: It facilitates transfer of purchasing power between countries,
➢ Credit function: It facilitates credit for international trade transactions,
➢ Hedging function: It facilitates protection against risk of exchange rate fluctuation
Convertible currency:
• A convertible currency is the monetary unit of a country where holders of the currency do
have right to convert it freely at the going exchange rate into any other currency.
• A currency is said to be convertible, if it can be converted into some other currency at the
market price of that currency.
• Major currencies which are example of fully convertible currencies including pound
sterling, USD, Japanese yen, euro.

Non-convertible currency:
• A non-convertible currency is the monetary unit of a country where holders of the currency
do not have the right to convert it freely at the going exchange rate into any other currency.
• A non-convertible currency is one that is used primarily for domestic transactions and is
not openly traded in the forex (FX) market.
• This is usually the result of government restrictions, which prevent it from being exchanged
for foreign currencies.
• A non-convertible currency is commonly known as a "blocked currency."

Exchange rate determination

• The foreign exchange market provides the physical and institutional structure through
which the money of one country is exchanged for that of another country, the rate of
exchange between currencies is determined, and foreign exchange transaction are
physically completed.

• Foreign exchange quotation is the price or rate quoted or determined to trade foreign
currencies between various parties of foreign exchange market.

• A foreign exchange transaction is an agreement between buyer and seller that give amount
of one currency is to be delivered at specified rate for some other currency. A foreign
exchange rate is the price of foreign currency. A foreign exchange quotation or quote is a
statement of willingness to buy or sell at an announced rate. Foreign exchange may be
direct, indirect and cross rate.

Direct quotation

• Direct quotation is when one unit of foreign currency is expressed in terms of domestic
currency. The quote is direct when the price of one unit of foreign currency is expressed in
terms of the domestic currency.
• A direct quote is an exchange rate quotation in the foreign exchange market.
• It quotes a fixed unit of a foreign currency against a variable amount of the domestic
currency.
For example
In Nepal,
1 USD = 131.39 NPR
USD/NPR

In USA
NPR/USD
1 NPR = USD 0.007611

Indirect quotation:

• Indirect quotation is when the one unit of domestic currency is expressed in terms of
foreign currency.
• The quote is indirect when the price of one unit of domestic currency is expressed in terms
of Foreign currency.
• An indirect quote is also known as a “quantity quotation,” since it expresses the quantity
of foreign currency required to buy a unit of the domestic currency.

In Nepal
NPR/USD
1 NPR = USD 0.007611

In USA
USD/NPR
1 USD = NPR 131.39

Cross currency rate:

• A cross rate is a foreign currency exchange transaction between two currencies that are
both valued against a third currency.
• In the foreign currency exchange markets, the U.S. dollar is the currency that is usually
used to establish the values of the pair being exchanged.
• When a cross-currency pair is traded, two transactions are actually involved.
• The trader first trades one currency for its equivalent in U.S. dollars. The U.S. dollars are
then exchanged for another currency.

➢ Convert Indian rupee into USD

➢ Convert USD into Euro

For example,
In India, If you need Euro and go to the bank and ask for Euro. Suppose bank said we do not
have Euro but USD. Take USD and cross rate for Euro.

1 USD = INR 82.10 (INR/USD)

 Now you go to another bank and asked for Euro, then Euro can be exchanged with USD

1 Euro = USD 1.10 (USD/Euro)

So, we need INR ? to get USD 1.10

USD 1.10 = INR 90.31

Then we can purchase 1 Euro from USD 1.10

So cross rate formula will be:

Cross rate = INR/USD x USD/Euro

INR/Euro = INR/USD x USD/Euro

= 82.10/1x1.10/1
= 90.31

The tie in with dollar ensures that all currencies are related to one another in consistent manner.

Interbank Foreign Currency Quotations

• Exchange rates, or in other words, prices for foreign currencies are expressed as a pair of
two different currencies and their relative prices. Which currency is the base and which
currency is the reference differs according to so-called European and American terms.
Accordingly we need to designate one of the currencies as the home currency and other as
foreign currency.
• The home currency price of one unit of foreign currency is called direct quotation. Thus to
person who consider the united states to be home, American terms represent direct
quotation.
• On the other hand the foreign currency price of one unit of home currency is called an
indirect quotation. European terms represent indirect quotation to people of united states.

Bid and ask quotation:

• The term "bid and ask" refers to a two-way price quotation that indicates the best potential
price at which a security can be sold and bought at a given point in time.
• The bid price represents the maximum price that a buyer is willing to pay for a currency.
A bid is the price i.e. exchange rate in one currency at which dealer will buy another
currency.
 • The ask price represents the minimum price that a seller is willing to take for that in
exchange of same currency. A ask is the price i.e. exchange rate in one currency at which
dealer will sell the other currency.
• A trade or transaction occurs when a buyer in the market is willing to pay the best offer
available—or is willing to sell at the highest bid.
• Dealer buy at bid price and sell at ask price, profiting from spread between bid and ask
price.
• A bid for one currency is also offer for the opposite currency.

For example:

1 USD = NPR 131.10 / NPR 131.47

Bid price Ask Price

➢ I am ready to buy 1USD @ NPR 131.10 per USD

➢ I am ready to sell 1USD @ NPR 131.48 per USD
➢ Bid – Ask spread = NPR 0.38 per USD

➢ Person A has USD 1000 with him and he wants to sell these dollar to the bank, then he will
get NPR 131,100
➢ Person B who wants to buy USD 1000 from the bank as bank has already said it will sell
USD at NPR 131.47 per USD. Then person B has to pay NPR 131,470.
➢ So difference between Ask and Bid price (spread) is NPR 370

Determination of rates of foreign currencies in Nepal

The exchange rate system, also known as the current system, establishes the value of a nation’s
currency against the currency of another nation. The exchange rate system is a critical
macroeconomic policy issue, especially for small open economies like Nepal. With increasing
globalization and global trade, a convenient exchange rate policy is needed to allow countries to
convert their currency to another currency to conduct smooth international trade.

Nepal has maintained the pegged system through a controlled supply of Indian Currency. When
the demand for Indian Currency increases, it causes the value of INR to become greater than the
pegged rate. To ensure that the exchange rate is maintained at NPR 160 to INR 100, the supply of
the Indian Currency needs to increase. The supply of the Indian Currency is controlled by NRB
with the help of its foreign exchange reserve.

Nepal Rastra Bank (NRB) introduced the pegged system with the intention to stabilize the Nepali
Currency and maintain its value in the international market by pairing it with a comparatively
powerful regional currency i.e. Indian Currency. Indian Currency is relatively powerful and stable
due to its high demand and supply in the international market.
Rate of US dollar is obtained on the basis of relationship of currencies INR and USD. Therefore
the rate of USD in terms of NPR is derived from cross rate of USD in reference with INR.

1 USD = INR 82.10 (INR/USD)

Now you go to another bank and asked for Euro, then Euro can be exchanged with USD

1 INR = NPR 1.6 (NPR/INR)

So cross rate formula will be:

Cross rate = INR/USD x USD/Euro

NPR/USD = INR/USD x NPR/INR

= 82.10/1x1.6/1
= NPR 131.36

After determining the rate of USD, rate of all other currencies are determined based on USD.

Determinants of exchange rates

Factors that influence currency exchange rates are important for various reasons. For countries,
these factors can affect how one country trades with another. For individuals, these factors affect
how much money one can get when exchanging one currency for another. Although it is not always
easy to understand, track, or even anticipate these factors, it pays to know them, especially if you
are interested in foreign currency. It is worth noting that these factors affect currency exchange
rates at a macroeconomic level, meaning they affect global currency exchange rates and not local
exchange rates.

1. Inflation

• Inflation measures how much more expensive a set of goods and services has become over
a certain period, usually a year.
• When inflation is high, the value of a country's currency weakens. This is because goods
become more expensive, and it becomes less attractive for investors to do business. The
inverse is also true.
• Countries with low inflation typically have stronger currencies compared to those with
higher inflation rates.
• For example there is low inflation in UK, then values of goods become cheaper than other
countries which have high inflation than UK. Then, importer are willing to import goods
from UK at lower price for which they need Pound Sterling. This will increase demand for
Pound Sterling resulting appreciation on value of Pound Sterling.
2. Interest Rates

• A country's currency will rise in value when interest rates are high because higher rates
will attract more foreign capital.
• This will lead to an increase in exchange rates and a strong currency. As a general rule, the
higher the interest rates, the more foreign investment a country is likely to attract and
demand for local currency will rise resulting appreciation in value of local currency and
opposite relationship exist if interest rate in decreasing.
• Higher interest rates tend to attract foreign investment, increasing the demand for and value
of the home country's currency. Conversely, lower interest rates tend to be unattractive for
foreign investment and decrease the currency's relative value.
• Further if these rate remain high for too long, inflation starts to rise resulting devaluation
in currency.

3. Current account deficit

• The huge import bill in the current account increases demand for foreign currency, while
slowdown in exports of goods reduces the inflow of foreign currency. The combined effect
exerts pressure on the exchange rate to depreciate (weaken).
• The current account balance is determined largely by the level of net exports (value of
exports minus value of imports of goods and services).
• A deficit occurs when payment for imports exceed receipts from exports. However, since
imports are financed in foreign currency, a widening deficit results in increased demand
for foreign currency. This means that the country is accumulating foreign liabilities locally.
• These liabilities would have to be paid through other sources of foreign currency such as
foreign interest earnings, loans, grants etc.
• For example, if a country has a positive balance of trade, it means that its exports exceed
its imports. In such a case, the inflow of foreign currency is higher than the outflow. When
this happens, a country’s foreign exchange reserves grow, helping it lower interest rates,
which stimulates economic growth and strengthens the local currency exchange rate.

4. Public Debt

• Countries with high amount of debt are less attractive to foreign investor due to chance of
default as well as possible high inflation rates. This can decrease value of currency.
• If country is in debt, it is understood that foreign capital is less, then there will be rise in
inflation, then foreign investor lose their confidence and withdraw their investment
resulting depreciation in currency value.
• Most countries finance their budgets using large-scale deficit financing. In other words,
they borrow to finance economic growth. If this government debt outpaces economic
growth, it can drive up inflation by deterring foreign investment from entering the country
narrowing demand for local currency which will depreciate currency value.
5. Terms of trade

• The Terms of Trade is the average price of exports / by the average price of imports. It is
a measure of a countries relative competitiveness.
• If export prices rise relative to import prices, we say there has been an improvement in the
terms of trade. – A unit of export buys relatively more imports. Generally, this leads to an
improvement in living standards as imported goods appear cheaper to consumers.
• If import prices rise relative to export prices, we say there has been a deterioration in the
terms of trade. Generally, this leads to a decline in living standards as foreign currency
earnings are relatively less and imported consumer goods more expensive.
• This, in turn, results in rising revenues from exports, which provides increased demand for
the country's currency (and an increase in the currency's value). If the price of exports rises
by a smaller rate than that of its imports, the currency's value will decrease in relation to
its trading partners.

6. Political Stability and economic performance

• A politically stable country attracts more foreign investment, which helps prop up the
currency rate. The opposite is also true – poor political stability devalues a country’s
currency exchange rate.
• If political and economic performance of country is not stable, then value of currency
depreciates as compared to currency where the political and economic performance are
better.
• Countries with a low risk of political uncertainty are more attractive for foreign entities to
make investments. Due to this, political stability increases demand for a nation's currency
and has a meaningful impact on forex rates.
• On the other hand, protests, coops, and political chaos have a destabilizing impact on the
economy and weakens the local currency.

8. Confidence/ Speculation

• Most trades in forex market are speculative trade which means that settlement and
momentum can play big roles in market activity. Even if fundamental don’t align, the
market for currency can continue soaring or depreciating if traders or governments perceive
• it should.
• If a country’s currency value is expected to rise, investor will demand more of that currency
in order to make profit in near future. As a result the value of currency will rise due to
increase in demand. With increase in currency value comes rise in exchange rate and vice
versa.
• Because of speculative transaction, foreign exchange rates can be very volatile.
• For example, traders may devalue a currency based on an election outcome, especially if
the result is perceived as unfavorable for trade or economic growth. In other cases, traders
 may be bullish on a currency because of economic news, which may appreciate the
currency, even if the economic news itself did not affect the currency fundamentals.

9. Government Intervention

• Governments have a collection of tools at their disposal through which they can manipulate
their local exchange rate.
• Primarily, central banks are known to adjust interest rates, buy foreign currency, influence
local lending rates, print money, and use other tools to modulate currency exchange rates.
• The primary objective of manipulating these factors is to ensure favorable conditions for a
stable currency exchange rate, cheaper credit, more jobs, and high economic growth.

10. Competitive advantage

• Competitive advantage refers when products of the country is cheaper and competitive than
products of other countries in international market.
• Competitive advantage may be obtained through technologically sound machineries,
availability of quality raw material and other resources at lower price, skilled manpower
etc.
• When price of the product is less in international market as compared to other countries,
export of the country increases which will result increase demand of local currencies in
other countries. This results in resulting appreciation in value of currency.

Foreign Exchange and Money Dealers Association of Nepal

Foreign Exchange and Money Dealers Association of Nepal (FEDAN) is a organization registered
with District Administration Office Kathmandu, on 20 th Poush 2052 B.S. (January 4, 1996 A.D.)
under Organization Registration Act 2034 (1977).

Foreign Exchange Dealers Association of Nepal (FEDAN)was established as an Association of

banks dealing in foreign exchange in Nepal is regulatory body and its major activities include
framing of rules governing the conduct of inter-bank foreign exchange business among banks vis-
à-vis public and liaison with NRB for reforms and development of forex market. An association
of banks specializing in the foreign exchange activities in Nepal. The Foreign Exchange Dealers
Association of Nepal, regulates the governing rules and determines the commissions and charges
associated with the interbank foreign exchange business.

Within the limitation of the prevailing Acts, laws and policies the objective and goals of FEDAN
are:
• To promote and develop inter-bank market and money market transaction in foreign
exchange,
 • To make coordination and interaction amongst central bank, financial institution and
governmental bodies in respect to banking activities relating to foreign exchange and
money market.
• To provide information about issues related to inter-bank foreign exchange and money
market to general public.
• To play role of arbitrator for settlement of problem if any divergence is created among the
member banks of this association in respect to money transaction.

Duties of FEDAN
• To enlist bank treasury dealers as authentic for treasury deal
• Timely fulfill the reporting requirement of Nepal Rastra Bank
• Deal with regulator like NRB, MOE on behalf of banking sector in the issue of foreign
exchange
• Represent Nepalese banking sector in front of foreign delegate in the national,
international seminar or issue relating with foreign exchange of Nepal
• Conduct timely meeting of banks treasury dealers
• Conduct training and development activities of the banks treasury dealer of Nepal

Responsibilities and functions of FEDAN

• Daily reporting of USD mid rate of 10:00 am and 2:00 pm to NRB of FEDAN’s
members along with the average mid rate of the particular time.
• Update and enlist the authenticate treasury dealers list
• Conduct timely meeting of FEDAN members to resolve any problems and discuss on
new issues.
• Timely settlement of disputes if any arises among FEDAN dealers and members
• Work in close contact with the regulators like NRB and MOE incase of FCY and money
market
• Ensure all FEDAN members to compile the compliance relating with dealers and
money market of Nepal

Nostro account
Nostro comes from the Latin word for "ours," as in "our money that is on deposit at your bank."

• A Nostro account is a bank account that a bank holds with a foreign bank in the domestic
currency of the country where the funds are held.
• It is used to facilitate the settlement of international trade and foreign exchange
transactions.
• The account is mainly held by banks or large corporations that regularly engage in
international trade transactions.
A Nostro account is a mechanism that banks use to keep track of all funds being held in other
banks in the currency of the country where the funds are held. The Nostro account is maintained
in a foreign currency that can be converted for use in foreign exchange and foreign trades.

For example, assume that Bank X maintains an account in Bank Y’s home currency. To Bank X,
the account will be treated as a Nostro account, while Bank Y will treat the account as a Vostro
account.

Vostro Account
• Vostro comes from the Latin word for "yours," as in "your money that is on deposit at our
bank."
• A Vostro account is a bank account held abroad through a relationship between two banks.
It provides the benefits that many consumers may need, but most domestic banks cannot
offer on an international scale.
• In most situations, Vostro accounts are used to manage foreign trades or settlements of
foreign exchanges.
• A vostro account is an essential part of correspondent banking in which a foreign bank acts
as an agent providing financial services on behalf of a domestic bank.
• Vostro accounts enable domestic banks to provide international banking services to their
clients who have global banking needs.
• Vostro account services include executing wire transfers, performing foreign exchange
transactions, enabling deposits and withdrawals, and expediting international trade.