Whenever business activities are restricted within a country, transactions are conducted in a single domestic currency. Accounting remains relatively simple and there is no exchange rate risk or uncertainty. However, the moment business goes global and involves more than one country, two or more currencies enter the picture, making financial transactions and accounting more complex. The moment a firm export, imports, borrows, invests, or licenses technology across borders, it becomes exposed to exchange rate fluctuations. Therefore, a clear understanding of forex concepts and the functioning of the foreign exchange market becomes essential.
For all finance students, knowing forex is important because it shows awareness of how foreign exchange market is evolving. Let’s go through the conversation of two students about forex.
The foreign exchange market, or forex market, is defined as the market where currencies are traded. Foreign exchange is the action of converting one currency into another. The rate that is agreed upon by the two parties in the exchange is called exchange rate.
It operates as an over-the-counter market without a central marketplace, allowing for the simultaneous buying and selling of currency. Exporters, importers, multinational companies, banks, central banks, investors, and speculators all participate in this market.
Two finance students, Joy and Neesha, are sitting in the cafeteria after their International Finance lecture.
Joy:
Today’s class on forex was interesting, but I’m still little bit confused. The professor kept talking about direct and indirect quotes. Aren’t the same? What is the difference?
Neesha was smiling:
They are related, but the perspective is different. Think from India’s point of view. When we say USD/INR = 88, it means we need Rs.88 to buy one dollar. That’s a direct quote for India.
Joy:
Oh! A direct quote expresses the home currency price of one unit of foreign currency.
Neesha:
Exactly. Now flip the viewpoint. If someone asks how much dollar one rupee can buy, we say INR/USD = 0.011. That’s an indirect quote.
An indirect quote expresses how much foreign currency one unit of home currency can buy
But direct quote is most commonly used in India and easy for importers and exporters to understand.
Joy:
So direct quote shows cost of foreign currency, and indirect quote shows value of our currency.
Neesha: Exactly.
Joy:
One more thing. How do appreciation and depreciation fit into this?
Neesha:
- A currency is said to appreciate when it becomes stronger and can buy more units of foreign currency.
- A currency depreciates when it becomes weaker and requires more domestic currency to buy one unit of foreign currency.
Indian Context (Direct Quote):
- If USD/INR moves from 83 to 82, the rupee appreciates.
- If USD/INR moves from 83 to 84, the rupee depreciates.
Joy:
That means appreciation makes imports cheaper and depreciation makes them costlier.
Neesha:
Exactly. And these movements create expectations about future exchange rates.
A few days later, Joy was looked at Neesha for some clarification regarding premium and discount.
Joy:
Neesha, suppose today the spot rate is USD/INR 88. But the 3-month forward rate is 88.50. What does that indicate?
Neesha:
It indicates that the market expects the rupee to depreciate. Since the forward rate is higher than the spot rate, the US dollar is at a forward premium.
Joy:
So importers will need more rupees in the future?
Yes. If the forward rate was lower than the spot rate, the dollar would be at a forward discount, indicating expected rupee appreciation.
Joy smiles….
So, premium and discount depend on how the exchange rate is quoted.
Neesha:
That’s why understanding forex basics is essential for international finance.Joy:
Now I get it. Uncertainty arises from exchange rate fluctuations, premium and discount indicate what the market expects in the future.