10:40 am - Wednesday June 28, 2017

Basic concepts in Foreign Exchange


The term foreign exchange is popularly referred to as the currencies of other countries. To an Indian, US Dollar is a foreign currency just as Indian Rupee to an American. Mr X, an Indian, receives a remittance of (say) USD 1000 from his relative in California, USA. Mr X cannot use this foreign currency in its original form, for US Dollar is not in legal tender in India. The foreign currency (US Dollar) has to be converted into Indian Rupee before being put into effective use. Similarly an Indian desirous of making a remittance of (say) Sterling Pound 250 to Institute of Bankers, London has to get his Rupee balance in his account converted into Sterling Pound before remitting.

Thus foreign exchange may be defined as

–          The currencies of other countries in the form of currency notes, drafts, telegraphic transfers, money transfers, travellers cheques, cheques etc

–          The method or mechanism by which currency of one country is converted into that of another

Need for conversion:

Any country, developed or developing, has to reach out beyond its barriers and boundaries to trade with other countries. The currency of each country is a legal tender only within its national boundaries.

Secondly, when countries trade there is no single universal currency in which the settlement can be made. The payment has to be effected either in the currency of the buyer or the seller or in a mutually accepted third currency. This necessitates the conversion of one currency into another.

Exchange Control:

The demand for foreign exchange arises on account of remittance to be made for imports, loan repayments, meeting personal expenses on account of education, travel, etc.

Export proceeds, inward remittances by non-resident Indians, loan availed from external funding agencies, etc form the sources of supply of foreign exchange.

In our country (India), the demand for (outflow) foreign exchange far exceeds the supply (inflow) of foreign exchange. Foreign exchange is therefore, a scarce commodity which is capable of being put into alternative uses. With a view to conserve this scarce commodity and to ensure its judicious use, Government of India monitors the use of this commodity through Reserve Bank of India. In other words, foreign exchange is subject to control by RBI under the Foreign Exchange Management Act and this control exercised is known as Exchange Control.

Trade Control:

International Trade is movement of goods resulting in movement of currencies. While control is exercised by Government of India on movement of exchange of currencies is known as exchange control, that exercised on movement of goods is known as trade control.

Role of RBI and Banks:

RBI administers the exchange business in India and they in turn delegated powers to banks to transact the actual exchange business. To ensure that all those handling exchange business observe uniform norms and procedures, RBI has handed the powers to Foreign Exchange Dealers’ Association of India to frame the guidelines for transacting exchange business.

Foreign Exchange Transactions:

Transactions that result in conversion of one currency into another are termed as foreign exchange transactions. The easier method of identifying a foreign exchange transaction is to (a) view the transaction from the bank’s (market’s) angle and (b) enquire as to what happens to foreign currency in question.

Settlement of foreign exchange transactions: (Nostro, Vostro and Loro accounts)

When a cheque or an export bill in foreign currency for USD 10,000 is purchased by any bank, he forwards the instruments/documents to the overseas correspondent for collection. On realisation, the foreign correspondent credits the proceeds to an account maintained by the bank with the correspondent.

Similarly when a bank issues a draft for USD 5000 on its correspondent abroad, the drawee bank honours the draft to the debit of the bank’s account with it.

The account maintained by the bank with its correspondent abroad is termed as bank’s NOSTRO account

Foreign correspondents also maintain rupee accounts with banks in India for settling their rupee transactions and such accounts are referred to as VOSTRO accounts by the banks in India.

Thus foreign exchange transactions are settled by entries in bank accounts maintained in select foreign centres. There is no physical transfer of funds from one centre / bank to another.

In simple terms Nostro accounts are foreign currency bank accounts maintained by banks in select centres abroad and Vostro accounts are local currency accounts (say, in Indian Rupees) maintained by foreign banks (say in India)

Just as one bank may have a nostro account with a foreign bank. Yet another bank may also maintain its nostro account with the same foreign bank. The first bank may refer to this account as Loro account.

Types of foreign exchange transactions:

Though foreign exchange transactions can be broadly categorised into purchase and sale transactions, all purchases and sales are not alike


When we purchase DDs, MTs or TTs, etc where the proceeds are already credited to the Nostro Account, the transaction is termed as TT purchase transaction.

Purchase of cheques, export bills, etc where foreign exchange will be credited to the nostro account only on realisation, is classified as bill buying transaction. Bill buying transactions are those which involve a time lag between the date of purchase and date of credit to the nostro account.


Issuance of clean instruments like DDs, MTs, TTs, etc for non import purposes are grouped under TT sales transaction

Sale towards payment of import bills are titled as Bill Selling transaction

Exchange Rate:

The rate at which a currency is converted into another is known as rate of exchange. It indicates the price of one currency in terms of another.

The rates can be fixed or floating. If it fixed, normally it would be fixed by a central authority in a country. If floating, it is decided by the market forces and players

Method of quoting rates:

The exchange rates can be quoted in two ways – direct quote or indirect quote.

In the direct quote, the foreign currency component is fixed (say, US Dollar) and the equivalent local currency component is fluctuating (say, Indian Rupee) as in 1 USD = 54 INR

In the indirect quote, the reverse will apply, wherein the local currency (say, Indian Rupee) will be fixed and the foreign currency (say, US Dollar) will be fluctuating as in 100 INR = 1.8519 USD

Foreign Exchange Markets

Like any other commodity, foreign exchange also has an active global market. It has a three tier market consisting of the following segments:

Merchant Market: Comprising of all banks and their export-import customers and others. Banks acquire exchange from their exporter customers and dispose of exchange to meet the needs of their importer customers.

Interbank Market: Constituted by banks alone

Overseas / international Market: Comprising of all banks dealing in foreign exchange in the global market place.

To sum up,

Foreign exchange ahs all commodity features, viz.,

It is scarce and subject to (exchange) control

It has a price (rate of exchange) decided by the forces of supply (inflow) and demand (outflow)

It has active (international) market and

Like the dealers in other commodities maintaining stock to meet requirements, banks dealing in foreign exchange maintain reserves in the form of balances in the nostro accounts abroad

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