Module 8 Currency & Commodity Futures

Chapter 2

Reference Rates & Impact of events

59

2.1 – Dual View

Think about a stock, Infosys for example, when you buy or sell Infosys – your view on the stock is straightforward – you are either bullish or bearish on Infosys therefore you buy or sell Infosys. Now think about a currency pair – say USD INR, when you buy or sell USD INR, whether you know or not, you have a dual view on the pair. For instance when you buy USD INR; it implies you are bullish on the US Dollar and bearish on the Indian currency.

Why is it this way you may ask?

Well, the value of a currency is always quoted against another. Recall from the previous chapter – the currency pair is quoted as –

Base Currency / Quotation Currency = Value

In other words, this format tells us, how many units of quotation currency one can buy for 1 unit of base currency.

If you buy a currency pair, clearly it implies that you expect the value of the pair to go up. Consider this example – USD INR = 65, one would buy the pair, hoping for the price of the pair to hit 68.

Now if the price of the pair is expected to increase, then it implies that going forward 1 unit of base currency can buy more units of quotation currency i.e. 1 USD to buy more INR.

M8C2-Cartoon

In other words, if the value of the pair goes up then the power of the Base currency goes up while at the same time the quotation currency weakens. This translates to you being bullish on the Base currency and bearish on the quotation currency at the same time.

Similarly if you sell the USD INR pair, it implies that you anticipate the Base Currency to buy lesser amount of quotation currency. This translates to you being bearish on base currency and bullish on the quotation currency.

Given this, “strengthening/weakening of a currency” refers to the following situations –

  1. Base currency strengthens when it can buy more units of quotation currency. For example USD INR moves from 67 to 68 it means the base currency (USD) strengths and the quotation currency (INR) weakens.
  2. Quotation currency strengths when the base currency buys lesser units of quotation currency. For example USD INR moves from 66 to 65 it means the base currency (USD) weakens and the quotation currency (INR) strengthens.

Note that strengthening and weakening of a currency is equivalent to a currency appreciating and depreciating. These terminologies are often used interchangeably.

Before we proceed, here is something you need to know. Just like a stock, the currency (and the currency pair) has a ‘two way quote’. The two-way quote enables one to identify the rate at which one can buy and sell the currency (and currency pair).

Don’t get thinking on the ‘two way quote’, it simply refers to ‘Bid and Ask’ rates J, but we do need to touch upon this as its vital to know how the two way quote works.

Have a look at the image below –

Image 1_spot 2 way quote

This is a snap shot of the currency spot rates, as quoted on a Forex trading site. For the sake of this discussion, I’ve highlighted the two way quote for EUR USD and GBP USD. The quote gives you the rate at which you can buy and sell the currency pair.

For example if you want to buy the EUR/USD – you will have to buy the pair at the ‘Ask’ price i.e. 1.1270. When you buy the pair, technically you are long EUR and short USD. Likewise if you want to sell the EUR/USD, then you would do so at 1.1269 (Bid price), and here you would be short EUR and long USD (remember the dual view concept).

The pairs are sometimes quoted in a short form, which is actually quite a popular way to quote currencies internationally. The shortened two way quote would be something like this for the EUR/USD pair –

EUR/USD – 1.1269/70.

If you notice in the shortened version, the ‘bid’ price is stated in full, but only the last two digits of ‘ask’ is stated.

Further, in the Forex lingo, digits are referred to as ‘pips’. Therefore, if the EURUSD moves from 1.1270 to 1.1272, then it means that the pair has moved 2 pips.

2.2 – Rate fixing and conversion path

As of today, the USD/INR rate stands at 67.0737. This rate is fixed by the RBI on a daily basis, and is called RBI’s ‘Reference Rate’; in fact RBI publishes these rates on a daily basis on their website. The Reference rate acts as crucial input for the currency futures trading as all settlements are based on this Reference rate.

Have a look at this –

Image 2_rbi ref rate

The above is a snapshot from the RBI’s site showing the reference rate for 14th June 2016. Do note, these are spot rates, and not future rates. Future rates are as seen on NSE’s website.

Anyway, the obvious question is – how does the RBI arrive at this rate?

Well, nothing hi tech here, RBI follows the age-old method of polling to arrive at the spot rate! Click here to see the RBI circular that explains the rate fixing procedure, but if you are in no mood to read the circular, you could read the following points that summarize the procedure.

  1. RBI has identified a list of banks based on their market share in the foreign exchange market. RBI calls them the ‘contributing banks’
  2. Every day between 11:30AM and 12:30PM  RBI calls a set of banks (randomly selected) listed under the contributing banks and ask them to give a two way quote on USD INR
  3. RBI collates these rates and averages out the rate based on the bid and ask
  4. The average rate is set as the USD INR rate for the day
  5. The same process is repeated every day except for weekends and bank holidays

It’s as simple as that!

The procedure is quite simple; however RBI polls only for the USD INR rates. For the other major rates i.e. EUR INR, GBP INR, JPY INR RBI adopts a technique called ‘Crossing’ also referred to as the cross rate mechanism.

While crossing, the direct rate of one currency is not available with respect to another. For example the direct rate of Euro with respect to INR is not readily available; one needs to cross these rates with a common denominator to arrive at the rates.

Let me take the example of deriving the EUR INR rate by crossing, keeping USD as the common denominator, hopefully this will give you a better clarity on the crossing technique.

Let us begin with getting the spot rate for USD INR, as we can see from snap shot above, the USD INR spot is –

USD INR – 67.0737

This is the spot rate; the two-way quote for this would be something like this –

USD INR – 67.0730 / 67.0740

This means if I have to buy 1 USD, I need to pay INR 67.0740 and if I have to sell 1 USD, I’d receive INR 67.0730.

Let’s keep this information aside. We now focus on EUR USD spot rates from the international markets.

The two-way quote from Bloomberg suggests –

EUR USD – 1.1134/40

This means I need USD 1.1140 (Ask price) to buy 1 Euro. In other words the cost of 1 Euro in terms of the US Dollar is 1.1140. Hence if I convert the price of 1.1140 USD to INR, then I will have enough INR to buy 1 Euro and by doing so, I will also get the EUR/INR rate.

Now going back to the USD INR rate –

1 USD = Rs.67.0740

1.1140 USD = How many Rupees?

= 67.0740 * 1.1140

= 74.72044

Hence to buy 1 Euro I need 74.72400 INR, or EUR INR = 74.72400

Notice how the USD acts as a pivot in the crossing technique.

Now here is a simple task for you – using the crossing technique, we have calculated the ASK price of the EUR INR pair, can you extend this logic to calculate the Bid price for the EUR INR pair? Feel free to post your answers in the comments section below.

If you think about this, it’s now clear that the reference rates and the cross rates change everyday based the sentiments of the contributing banks. This leads us to a bigger question – what influences the sentiment of the contributing banks?

The answer is quite simple – domestic and international events.

2.3 – Events that matter

Think about an event that can potentially change the sentiment on a stock. Quarterly result of company is one such event. Estimating the change in sentiment based on this event is quite straightforward. If the quarterly result is good, the sentiment is positive; therefore the stock price is expected to go up. Alternatively, if the quarterly result is not great, sentiment is hurt and therefore the stock price is expected to go down. The point here is, there is some sort of linearity between the event and the expected outcome.

However when it comes to currency pairs, there is no such linearity, which makes it a herculean task to assess the impact of events, a.k.a. fundamentals on currencies. The complexity mainly stems from the fact that currencies are quoted as pairs. While some factors lead to strengthening of a pair, an event could occur at the exact same time that weakens the pair.

Let me give you an example to illustrate this – imagine two economic events running in parallel. Event 1 –   India receives a continuous inflows of Foreign Direct Investments (FDI) geared towards long term investments, clearly this is a big positive for the economy and therefore it tends to strengthen the INR. Event 2 – There is an uptick in the US economy (or a fear of a crash in commodities) leading to an appreciation in the US Dollar.

Given these two events occur in parallel – which direction will the USD INR currency pair move? Well, the answer to this is not straightforward. Eventually the currency pair will take cues from the more dominant of the two factors and head in that direction, but until this happens the pair invariably exhibits volatile behavior. Hence, to successfully trade currencies, it becomes extremely important to track world events and assess their impact on the currency pair in question.

Here are few such events and data that you should track –

Import/Export Data – These numbers are highly significant, especially for a country like India, whose economy is highly sensitive to trade deficits. India exports goods and services such as rice and software and imports commodities such as crude oil and bullion.  In general, increase in exports tends to strength domestic currency and increase in imports tends to weaken the domestic currency. Why so you may ask?

When imports are made (crude oil for example), the purchase has to be made in the International market which requires one to pay in USD. Therefore one has to sell INR and buy USD to facilitate this purchase, which in turn causes a demand for USD and hence USD strengths.

We can extend the same logic to exports. When we export goods, we receive USD; we sell the USD received and convert to INR. This causes the INR to strength.

The Trade Deficit – the excess of imports over exports is a key factor to track as it influences the direction in which the currency trades. In general, narrowing the trade deficit is a positive for the domestic currency. The trade deficit is also referred to as the ‘Current account deficit’. I’d suggest you read this news piece, just to reinforce your understanding on this topic.

Interest RatesTypically investors borrow money from countries where the interest rate is low and invest in countries where the interest rates are high and profit from the interest rate difference. This is called the ‘carry trade’. Clearly the country offering higher interest attracts a lot more foreign investment into the country, naturally this leads to the strengthening of the domestic currency. This clearly implies that the ‘Interest rate’ is one big number currency traders watch out for.

The monetary policy review conducted by the central banks (RBI in India, Federal Reserves in US, and ECB in Euro region) reviews the interest rates of the country. This is the reason why there is so much attention paid for the policy review. Besides tracking the actual change in numbers in the on-going review, the market participants look for cues regarding the policy stance. The monetary stance helps the participants understand the future course of action concerning the interest rate.

DovishDovish is a term used to describe the central bank’s stance wherein they are likely to lower the interest rate in the future. Remember, lower interest rate weakens the domestic currency. Here is a new headline talking about the relationship between a dovish stance and the currency.

Image 3_dovish

Click here to see the article.

HawkishHawkish is a term used to describe the central bank’s stance wherein they are likely to increase the interest rate in the future. Remember, higher interest rates attract foreign investments to the country and therefore strengthens the domestic currency.

And here is another new headline which talks about hawkish stance.

Image 4_hawkish

InflationInflation, as you may know, is the rate at which the prices of basic goods and services increase over time. If inflation increases, then it means the cost of basic necessities is increasing, therefore this affects the day to day living of the common man. Given this, the central bank strives hard to keep inflation in control. The link between inflation and currency movement is a bit tricky.

One of the direct mechanisms to curb inflation is by tweaking the interest rates. If the inflation is perceived as high, then the central bank is likely to take a hawkish stance and increase the interest rates.

What do you think is the logic here?

Well, easy money in the hands on consumers and corporates increases spending; when spending increase merchants smell an opportunity to make higher margins and therefore this leads to rapid increase in prices, and thus the inflation increases. When inflation increases, the central banks tend to curb the spending by cutting the access to easy money. And how do they do that? Well, they increase the interest rates!

Therefore, when inflation is on the rise, expect the central banks to take a hawkish stance and increase the interest rates. When interest rates increase, the domestic currency strengths!

Therefore, as I mentioned earlier, the relationship between interest rates and currencies is a little tricky. So traders eagerly track inflation data to figure out what the central banks are likely to do, and accordingly take positions on the currency pair.

Remember this – if the inflation is high, expect a hawkish stance by the central government and therefore expect the domestic currency to strengthen. Likewise, if inflation is low, expect a dovish stance (as the central bankers wants to encourage spending), therefore the interest rates are likely to come down. This leads to the domestic currency weakening.

Consumer Price Index (CPI) – The CPI is a time series data, averaged out to capture the prices of basic goods and services. Hence the CPI is a measure for inflation. A rising CPI means inflation is increasing, and vice versa. For the most accurate Indian CPI data and information check this website

Gross Domestic Product (GDP) – The GDP of a country represents the total Rupee value (for Indian GDP of course) of all the goods and services produced in the country for a given year.  As you can imagine the GDP would be a massive number and it does not make sense to repeat the GDP number while making estimates or during conversations. Therefore one always refers to the GDP as a growth rate. For example if the GDP of a country is 7.1%, it means that the GPD number is growing at a rate of 7.1%.

Higher the GDP growth rate, higher is the investor confidence in that country, and therefore the stronger the countries domestic currency.

The list of events that matter while trading currencies is virtually endless, and at some point you will realize that every piece of data you can possibly look at is inter-connected with one another. Honestly, you need not know the details of each event the way an economist would. Understanding the cause and effect relationship is good enough. I’ve listed some of the key events/data points that matter while trading currencies. I guess this would serve as a good start, If nothing more.


Key takeaways form this chapter

  1. The base currency is said to strengthen/appreciate against the quotation currency when it can buy more units of quotation currency.
  2. The base currency is said to weaken/depreciate against the quotation currency when it buys lesser units of the quotation currency.
  3. When you go long on a currency pair, you are essentially going long on the base currency and short on the quotation currency.
  4. When you go short on a currency pair, you are essentially going short on the base currency and long on the quotation currency.
  5. The RBI sets the reference rate of USD INR on a daily basis by conducting a poll, the ‘contributing banks’ participate in this poll.
  6. The reference rates for other currency pairs are derived by crossing technique.
  7. Understanding events and its impact on currencies is complicated, simply because of the currency is quoted in pairs and impact on the pair could be similar.
  8. Eventually the more dominating event will set the direction for the pair.
  9. Countries with higher interest rates tend to have stringer currencies and vice versa.
  10. Lower the trade deficit of the country, stronger is the country’s currency.
  11. Higher inflation leads to strengthening of currency and vice versa.
  12. Knowing the cause and effect of events on currencies helps while trading currencies.

59 comments

  1. ShreyaDR says:

    as per my calculation Bid price of EURINR 74.6790782

  2. ShreyaDR says:

    what is Repo Rate n Reverse Repo Rate? is it related to currencies anywhere?

  3. karthi says:

    Hello Sir,
    I have a general doubt. Are the financial instruments same in india and other global markets? If not what additional knowledge do we need to aquire. I’m interested in US markets.

    • Karthik Rangappa says:

      The basic functioning of the futures instrument would be the same, but logistics (expiry, lot size etc) would change.

  4. CHAITANYA KALE says:

    Namaste to u market GURU.!

  5. Manoj says:

    Sir, when can I expect updates on commodity markets? Eagerly awaiting!!!

  6. dev says:

    Hi is there any method to separate the boring candle in the chart by separate color in candle stick pattern…

  7. sarath says:

    BID PRICE OF EURINR IS 74.6801 RIGHT?

  8. Divakar says:

    Hai sir how can we calculate trend side up or down and find the future.. crude oil..in day

  9. Rakesh.K says:

    Hi karthik, a small doubt
    today the reference rate of USD/INR is 66.8804. and in spot market USD/INR is 67.07.
    now my doubt is what is the exact use of this reference rate (is this ref rate is only useful for calculating cross currencies OR there is any other use).???
    please kindly clear my doubt.
    Thanks&Regards

    • Karthik Rangappa says:

      Reference rate is updated once a day at the end of the day. Ref rate is the one based on which the futures market works. Btw, USD/INR of 67.07 is the futures rate and not really the spot.

  10. NareshS says:

    Hi Karthik
    What exactly is interest rate? Is it lending rate (loans) or borrowing (deposits) rate or both?
    What I understood from this is that FII’s are attracted towards high interest rate…obviously that would mean high returns on their investment/deposits right?
    Now why would RBI increase interest rate (read as deposit rate) if inflation is high? So that people could deposit money in bank instead of spending on commodity leading to inflation? Am I right?
    My understanding is this…please please correct me if I am wrong.
    More Inflation = Increase in interest rate = Increase in FII = strengthening of economy = Bull market
    So basically inflation is good for market makes my head go dizzy. Please explain

    • Karthik Rangappa says:

      Interest rate is a regulator knob of your ceiling fan. Higher the interest rate, lower is the circulation of money in the economy…afterall, who wants to borrow at higher rate?

      So when inflation is high, central banks try to curb the supply of money by tightening the supply of money….and the way to do this is by maintaining higher interest rates in the economy.

      Yes, once interest rates are high, deposits tends to give higher yeilds…but this may not be very good for the markets right? Why would you want to move away from a high yielding FD to a risky asset like equity?

  11. Kaushik says:

    How to trade EUR USD?
    When it will be available in Zerodha?

    • Karthik Rangappa says:

      RBI has given the approval, not sure when the exchanges will take it live. Moment its on the exchange, it will be available with us.

  12. Will it be possible to show the USD or JPY current exchange rates with INR in trading terminal itself?

  13. Debojyotydatta says:

    Nitin Ji, Being new to forex I want to know the following:
    1. If I buy 1lot(1000) USD/INR for december 16 future at 67.5 and when price falls to 67 on that same day , then will I be able to square off on that day or i would have to hold it for last settlement day
    2.If USD/INR rises to 68 it means I am incurring loss and If it falls to 67 it means I am incurring profit ? Plz correct me on that

    • Karthik Rangappa says:

      1) You can square off the same day, no need to hold to expiry.

      2) If you are long, you will make a profit if the price increases and make a loss if the prices fall.

  14. Tushar Gadodiya says:

    Sir, in the above calculation of “Ask” price for EUR INR you have multiplied “Ask” price of EUR USD with “Bid” price of USD INR. Should it not be the multiplication of “Ask” price of both EUR USD & USD INR ?

  15. 9SR says:

    Hi !
    When we compare forex vs stocks, with my limited knowledge, I came to this conclusion that
    apart from having high liquidity, round the clock trading hours and no stt, forex is less lucrative compared to stock trading. Please correct me if I am wrong.

  16. AMIT KUMAR PANDEY says:

    sir i m a bit confused , pls correct me-
    increase in interest is a BEARISH sentiment for STOCK MARKET as corporates will get fund on higher interest ; Whearas BULLISH sentiment for CURRENCY market as Foreign investors invest in indian market creating demand for INR .
    pls correct me if my view is wrong.

  17. Rajat Saini says:

    Sir, I m confused about relation b/w
    1. GDP and Interest rate
    2. GDP and currency
    3. Interest rate and currency
    Above it is explained that Higher GDP means more confidence = stronger domestic currency
    Higher interest rate = More foreign investment = stronger domestic currency
    But confusion comes with Interest rate vs GDP on currency.
    Isn’t it higher interest rate= low GDP or vice versa.
    Which leads to opposite conclusion i.e. higher interest rate = weaker domestic currency due to low GDP

    • Karthik Rangappa says:

      Not really. Frankly these variables share a complex relationship. Think about it – higher interest rate tends to attract higher foreign investments which is in turn good for GDP…leading to stronger domestic currency. However, it also depends on how the markets perceive interest rate, while the monetary authority may look at it as a stable rate, markets may have an opposite view. This is where the complexity arises.

  18. Abhijit says:

    Hey Karthik, thanks a ton for valuable info.

    You said when we import we sell INR and buy USD which creates demand of USD and strengthen it.

    And when we export, we get USD and convert it to INR. Which means if we bought from country XYZ, they bought USD with their currency and paid us, which again increases demand of USD and strengthen it.

    So doesn’t it make USD kind of invincible currency which is always in demand? Or am I missing something?

  19. Rupam says:

    How can I search EURO USD pair in zerodha

    • Karthik Rangappa says:

      Euro USD is not available on exchanges, so you will not find it on Zerodha or for that matter any broker.

  20. Manish says:

    If RBI sets the currency rate by consulting selected banks and the average is selected as the currency rate then how does the currency rate keep on fluctuating every second?

  21. Manish says:

    Why does the rbi increase the interest rate during inflation it should decrease the inflation instead so that there is enough money floating in the market

  22. Rakesh says:

    What about the opening price of rupee we see daily on news at 9 am. Is it future price or spot price

  23. Manish Thakkar says:

    Can we get eventwise impact on currency in tubular presentation ? It will surely help to understand and quick decision making .

    Thanks, Karthik

  24. Prakhar says:

    The interest rate of RBI referred in above paragraph is the rate which account holder gets by depositing money Right? Or is it the repo rate which had been discussed.

  25. KP says:

    Hi,
    As , FED increased interest rates in US by 0.25% then this should strengthen USD right and if yes , then why USDINR went down?

    • Karthik Rangappa says:

      The exit polls of Gujarat sate assembly indicates BJP will make a clean win, which implies the voter sentiment may not have changed for the next year Lok Sabha elections. Which market participants believe is good for the economy and the currency.

  26. Sathiya says:

    What’s the currency trading time?. Isn’t 24 hours. In India 9 to 5?

  27. ayush says:

    1. Does contributing banks means that they participate in forex market or they have their bank listed in forex market?
    2. why RBI polls out only USD/INR rates except EUR/USD, GBP/USD and USD/JPY rates from contributing banks?
    3. why does they compute crossing if they can directly get the detail ofother pair from contibuting banks?

    • Karthik Rangappa says:

      1) Contributing banks also participate in Forex markets.
      2) Only USD?INR as far as I know
      3) I’m not sure about this, Ayush.

  28. Prattham Pant says:

    There are two Interest Rates
    One is Repe rate (Lending rate for banks ) and the T-Bill Rate (for the investment purpose) . What interest rate are you talking about when explaining thins above ?

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