Currency markets: basics

Every importer, exporter, NRI and foreign investor in India carries currency risk, and the exchange-traded currency segment exists to let them manage it. The exam tests whether you can read a quote correctly, say who gains when the rupee weakens, and explain why a forward rate differs from spot. Get these basics right and the next two chapters on futures and options become arithmetic.

Reading an exchange rate

A currency pair is written as base/quote. In USD/INR 84.0000 the base currency is the US dollar and the quote currency is the rupee: one dollar costs 84 rupees. The number tells you the price of one unit of the base in units of the quote. In India this is a direct quote, because the foreign currency is priced in home currency. An indirect quote would say INR/USD 0.0119, the number of dollars one rupee buys, and it is rarely used here.

Dealers quote two prices. The bid is what the dealer pays to buy the base currency; the ask (or offer) is what the dealer charges to sell it. A quote of 83.9800 / 84.0200 means the bank buys dollars at 83.98 and sells them at 84.02. The gap of ₹0.04 is the spread, the dealer's margin. A customer always deals on the worse side: an importer buying dollars pays 84.02, an exporter selling dollars gets 83.98.

When USD/INR rises from 84 to 85, the dollar has appreciated and the rupee has depreciated. More rupees are needed for each dollar. Importers lose, because their rupee cost goes up; exporters gain, because each dollar they earn converts to more rupees. Reverse all of that when the pair falls.

Pairs that do not involve the rupee are cross rates, and you derive them by chaining two quotes. If EUR/USD is 1.1000 and USD/INR is 84.00, then EUR/INR is 1.10 × 84 = 92.40. The smallest unit of a quote is a pip, usually the fourth decimal place; on Indian exchanges the tick is 0.0025, as specified by the exchange.

Spot, forward and the premium

A spot deal is settled two business days after the trade (T+2) in the interbank market; same-day and next-day deals are called cash and tom. A forward fixes today the rate at which currency will be exchanged on a later date, say three months out. Forwards in India are over-the-counter contracts with banks, which are authorised dealers under RBI rules, and they traditionally required an underlying exposure such as an import order or a foreign currency loan.

The forward rate is not a forecast. It is set by the interest rate differential between the two currencies. If rupee deposits earn 6.5% and dollar deposits earn 4.5%, holding rupees pays 2% more a year. If the forward rate equalled spot, everyone would borrow dollars, convert, earn the rupee rate and lock the conversion back, a riskless profit. To remove that, the dollar must trade at a forward premium that roughly equals the differential. This is interest rate parity.

The currency with the higher interest rate always trades at a forward discount, and the one with the lower rate at a premium. Since Indian rates have been above US rates for decades, the dollar is almost always at a premium against the rupee, so forward USD/INR is above spot. If a question gives you a forward below spot, it is telling you the rupee rate is lower than the dollar rate, which is unusual but arithmetically consistent.

Who uses currency derivatives and why

• Importers must pay dollars later. They fear a rising USD/INR, so they buy dollars forward or buy USD/INR futures or calls.
• Exporters will receive dollars later. They fear a falling USD/INR, so they sell dollars forward, sell futures or buy puts.
• Borrowers in foreign currency, such as a company with an external commercial borrowing, have the same exposure as importers on every interest and principal payment.
• Foreign portfolio investors hold rupee assets and will convert back to dollars later. They fear rupee depreciation, so they buy dollars forward or buy USD/INR futures, the same side as an importer.
• Banks make markets and manage their own net open position within RBI limits.
• Speculators and arbitrageurs provide liquidity. A speculator takes a view on the pair; an arbitrageur trades the gap between the OTC forward, the exchange futures and the interest rate parity level.

The exchange-traded market adds three things the OTC market lacks: a transparent screen price, a clearing corporation that removes counterparty risk through novation, and small lot sizes (USD 1,000) that let a small business or retail trader hedge amounts a bank would not quote.

The regulators

Currency is unusual in having two regulators. The RBI regulates the foreign exchange market under the Foreign Exchange Management Act, 1999 (FEMA). It licenses authorised dealers, manages the exchange rate through intervention under India's managed float, sets the rules on who may take positions and whether an underlying exposure is needed, and publishes the daily reference rate (now computed by Financial Benchmarks India, FBIL) that exchange contracts settle against. SEBI regulates the exchanges, clearing corporations and brokers through which currency futures and options trade. The two coordinate through an RBI-SEBI standing technical committee, and product changes such as new pairs or longer tenors need both.

The timeline matters for the exam: RBI permitted exchange-traded currency futures in 2008, NSE launched USD/INR futures in August 2008, EUR/INR, GBP/INR and JPY/INR followed in 2010, USD/INR options were introduced in October 2010, and cross-currency pairs (EUR/USD, GBP/USD, USD/JPY) were permitted in 2018. Only Indian residents and specified non-resident categories such as FPIs may trade, within position limits, and only through SEBI-registered trading members. Settlement is always in rupees; no foreign currency ever changes hands on the exchange.