Currency Chapter Notes

Chapter 1: Introduction to Currency Markets

NISM Series I — Currency Derivatives | ~9% weightage | ~56 questions

What this chapter is about

Before you trade a single USDINR futures contract, you need to understand what currency markets are, how exchange rates are quoted, and why currencies move. This chapter is the foundation for everything else. It's also the chapter with the most calculation-based questions — cross rates, real returns on overseas investments, and gold standard math appear in almost every exam set. Get comfortable with currency arithmetic here and you'll find CH3 and CH5 much easier.

Key concepts

What is an exchange rate? The price of one currency expressed in terms of another. USDINR = 84 means 1 USD costs Rs 84.

Base currency vs Quotation currency:

• In a currency pair, the FIRST currency is the base
• The SECOND currency is the quotation (price) currency
• USDINR: USD is base, INR is quotation
• EURUSD: EUR is base, USD is quotation
• In the interbank market, USD is the universal base currency for most pairs

Bid vs Ask (from the bank's perspective):

• Bid = price at which the bank/market maker will BUY the base currency
• Ask (Offer) = price at which the bank/market maker will SELL the base currency
• For an exporter receiving USD: they SELL USD to bank → get the BID price
• For an importer buying USD: they BUY USD from bank → pay the ASK price
• Spread = Ask − Bid (the bank's profit, widens for larger transactions)

Currency systems:

• Free float — market forces determine the rate. All major currencies (USD, EUR, GBP, JPY, CHF, AUD, CAD) are free floating.
• Managed float (Dirty float) — market determines rate most of the time, but central bank intervenes occasionally to reduce excessive volatility. India's INR operates on a managed float.
• Fixed/Pegged — rate fixed to another currency or gold. Historical only (Bretton Woods system, gold standard).

Gold Standard — historical system where currency values were tied to gold.

Exchange rate = Gold price in Currency A / Gold price in Currency B
Example: If 1 oz gold = Rs 54,000 and 1 oz gold = USD 675
Then 1 USD = 54,000 / 675 = Rs 80

Bretton Woods System — post-WW2 system where USD was pegged to gold at $35/oz, and all other currencies were pegged to USD. Collapsed in 1971 when the US abandoned the gold peg.

Cross rates — the most tested calculation

A cross rate is an exchange rate between two currencies derived via a third currency (usually USD).

Formula:

EURINR = EURUSD × USDINR
Cross rate bid = lower currency bid × lower USD bid
Cross rate offer = higher currency offer × higher USD offer

Example: EURUSD = 1.1650/1.1655, USDINR = 85.35/85.40

EURINR bid = 1.1650 × 85.35 = 99.43 EURINR offer = 1.1655 × 85.40 = 99.54

GBPINR calculation: GBPUSD = 1.34/1.3425, USDINR = 86.5/86.52 GBPINR bid = 1.34 × 86.5 = 115.91 GBPINR offer = 1.3425 × 86.52 = 116.15

Real returns on overseas investment — most repeated numerical

This type appears in every exam. The formula never changes.

Steps:

1. Convert INR → foreign currency at entry rate (divide)
2. Apply investment return in foreign currency terms
3. Convert back at exit rate (multiply)
4. Calculate % return in INR terms

Example: Indian investor puts Rs 3,90,000 in US stocks when USDINR = 65.

• USD invested = 3,90,000 / 65 = 6,000 USD
• Investment grows 25% in USD: 6,000 × 1.25 = 7,500 USD
• Repatriated at USDINR = 62: 7,500 × 62 = Rs 4,65,000
• Real INR return = (4,65,000 − 3,90,000) / 3,90,000 = 19.23%

Key insight: Even if the investment grows in USD, if INR appreciates (USDINR falls), your INR returns get compressed. If INR depreciates (USDINR rises), your INR returns get boosted.

Macroeconomic factors that move currencies

The simple rule: Things that attract foreign money into a country strengthen its currency. Things that push money out weaken it.

Real market example — how USDINR moves

January 2024: RBI keeps rates steady while US Fed signals rate cuts. The interest rate differential between India and US narrows. This makes Indian assets slightly less attractive to foreign investors. Result: some capital outflow, mild INR depreciation, USDINR moves from 82 to 84.

Separately, strong US retail sales data comes out. This signals a robust US economy. Investors expect the Fed to delay rate cuts. USD strengthens globally — USDINR moves up further to 84.50.

Trap Alert

Trap 1: "Bid price is always lower than ask price" — TRUE but don't confuse direction For USDINR, if quote is 83.10/83.12:

• Bank buys USD at 83.10 (you sell USD at 83.10 — EXPORTER gets this)
• Bank sells USD at 83.12 (you buy USD at 83.12 — IMPORTER pays this)

Trap 2: "Cross rate uses bid×offer and offer×bid" — WRONG EURINR bid = EURUSD bid × USDINR bid (both bids) EURINR offer = EURUSD offer × USDINR offer (both offers)

Trap 3: "A managed float currency has no central bank intervention" — FALSE Managed float = market + OCCASIONAL intervention. That's the whole point.

Trap 4: "Vehicle currency increases number of exchange rates to deal with" — FALSE Vehicle currency (USD) REDUCES the number of exchange rates needed in a multilateral system. Instead of quoting every currency pair directly, you quote everything vs USD.

Must-remember rules

• Base currency = first in the pair; Quotation = second
• Exporter SELLS foreign currency → gets BID price
• Importer BUYS foreign currency → pays ASK price
• Free float majors: USD, EUR, GBP, JPY, CHF, AUD, CAD
• INR = managed float (RBI intervenes when needed)
• Cross rate EURINR bid = EURUSD bid × USDINR bid
• Real INR return: Convert INR→USD at entry, apply return, convert back at exit
• Higher interest rates → currency tends to appreciate (capital inflows)
• Spread widens for large transactions, narrows when market is more liquid

Weightage note

~9% = ~56 questions. Cross rate numericals appear in every single exam set — expect 3-4 per exam. Real returns calculation appears 1-2 times per exam. Currency movement analysis (appreciating/depreciating) appears 4-5 times per exam. Master the arithmetic and you'll score full marks on this chapter.

Quick revision — 60 second scan

• Base = first currency | Quotation = second
• Bid = bank buys | Ask = bank sells (always from bank's perspective)
• Cross rate: EURINR = EURUSD × USDINR (bid×bid, offer×offer)
• Real return: INR → USD at entry → apply return → USD → INR at exit
• Free float majors: USD, EUR, GBP, JPY | INR = managed float
• Gold standard: rate = gold price A / gold price B
• Higher GDP/rates/capital inflows = currency appreciates