NISM Series I Currency Derivatives – Chapter 1: Introduction to Indian Currency Market
If you are preparing for the NISM Series I Currency Derivatives Certification Exam, understanding the Indian currency market is your first and most important step. This post covers all the foundational concepts you need — from the history of forex to key economic indicators — so you can walk into the exam fully prepared.
At PassNISM.in, we break down every chapter of the NISM curriculum into simple, exam-ready notes. Let's get started with Chapter 1.
What is Foreign Exchange (Forex)?
Before modern banking, people traded goods for goods — a system called the barter system. The barter system had three major problems: goods could not always be divided, transporting them was costly, and valuing services was difficult.
Over time, societies shifted from food items and metals to paper currency. People deposited gold or silver coins with banks and received paper notes whose value was backed by those coins. As international trade grew, the need to compare the value of one country's currency against another gave rise to foreign exchange (FX or forex).
Whenever cross-border trade happens, one currency must be exchanged for another. That act of exchanging two currencies is called foreign exchange.
History of the International Currency System The Gold Standard (Around 1870)
Around 1870, countries agreed to value their currencies against gold. Every currency had a fixed gold equivalent, which made international trade more predictable.
The Bretton Woods System (1944–1971)
After World War II, a landmark agreement was signed at Bretton Woods, USA. Under this system:
- All currencies were pegged to the US Dollar (USD) at a fixed rate
- The USD itself was pegged to gold
- This made the USD the dominant global currency
The Bretton Woods System was eventually suspended, and countries moved to either a free-floating or managed float system of currency valuation.
Post-Bretton Woods Era
Developed countries largely adopted market-determined exchange rates, while developing countries like India adopted a managed exchange rate — where the central bank (RBI) intervenes to prevent extreme currency movements.
Exam Tip: Remember that in the Bretton Woods System, currencies were pegged to USD, and USD was pegged to gold. After its suspension, free float and managed float emerged. Major Currency Pairs You Must Know
The most traded currency pairs in the world are collectively called the "Majors." These currencies all follow the free-floating method of valuation. Here is a quick breakdown:
| Currency | Symbol | Key Fact for Exam |
|---|---|---|
| US Dollar | USD | Most widely traded; used as investment, reserve, transaction, invoice, and intervention currency |
| Euro | EUR | Second most important currency globally after USD |
| Japanese Yen | JPY | Third most traded; very liquid globally |
| British Pound Sterling | GBP | Was the global reference currency until end of WWII; nickname "Cable" (from Atlantic telegrams) |
| Swiss Franc | CHF | One of the most stable currencies; widely used as reserve currency |
| Australian Dollar | AUD | Part of the Majors group |
| Canadian Dollar | CAD | Part of the Majors group |
Overview of International Currency Markets
The forex market is unique because it operates 24 hours a day. As financial centers in one part of the world close, others open — creating a continuous trading cycle that spans Tokyo, London, New York, and other major hubs.
Because multiple markets are active simultaneously, the exchange rates for major currencies tend to be nearly identical across all financial centers. The opportunity for large price discrepancies (that would allow easy arbitrage) is extremely rare because markets correct almost instantly.
At any given time, all active financial centers together form a single, integrated global market.
Basics of Currency Markets and Indian Peculiarities Currency Pairs
In currency trading, you always buy one currency and sell another. This means the value of one currency is always measured in terms of another — making the market inherently about pairs, not individual currencies.
Base Currency vs. Quotation Currency
- Base Currency (BC): The currency being priced; its amount is fixed at one unit
- Quotation Currency (QC): The currency used to price the base currency; its amount varies with market prices
For example, in the currency pair USD/INR, USD is the base currency and INR is the quotation currency. If USD/INR = 84, it means 1 USD buys 84 INR.
Interbank Market vs. Merchant Market
- Interbank Market: Banks trade among themselves and quote both buy and sell prices simultaneously (two-way quotes)
- Merchant Market: Merchants (businesses/individuals) are generally price takers; banks are the price givers
Large corporations may sometimes ask banks for two-way quotes if they have interest in both buying and selling.
Two-Way Quotes
In any two-way quote, two prices are given:
- Bid Price: The price at which the dealer buys the base currency (lower price, quoted first)
- Offer/Ask Price: The price at which the dealer sells the base currency (higher price, quoted second)
When the currency pair is quoted to four decimal places, the offer price is usually stated as only the last two decimal places.
Appreciation vs. Depreciation
When the base currency buys more of the quotation currency than before, the base currency has appreciated and the quotation currency has depreciated. Exchange rate changes are also described as one currency strengthening or weakening against another.
Market Timing in India
- The OTC (Over-the-Counter) forex market in India is open from 9:00 AM to 5:00 PM
- For merchant transactions, the market is open from 9:00 AM to 4:30 PM
- The last half hour (4:30 PM to 5:00 PM) is reserved for interbank dealings only, allowing banks to square off excess positions
Key Price Benchmarks in the Indian Forex Market Interbank Rate (IBR)
For large-value merchant transactions, banks use the Interbank Rate (IBR) — the price available to that bank in the interbank market. Since IBR can differ between banks, two merchants at different banks may get slightly different rates.
Card Rate
For small-value transactions, banks publish a card rate — a standard price for the day. On most days, the card rate remains the same for all transactions at that bank throughout the day.
Price Discovery
As buy and sell orders are matched in the market, an equilibrium price emerges. The process of discovering this equilibrium is called price discovery.
RBI Reference Rate
The RBI Reference Rate is the official spot rate published daily by the Reserve Bank of India for various currency pairs. The RBI periodically reviews and updates the methodology used to arrive at this rate, ensuring it accurately reflects actual market activity. Large-value transactions in OTC markets increasingly use the RBI reference rate as a benchmark.
Settlement in the Forex Market Trade Date vs. Value Date
- Trade Date: The date on which both counterparties agree on the transaction (currency, price, amount, and value date)
- Value Date (Settlement Date): The actual date on which the currencies are exchanged between counterparties
Spot Date
The most commonly used value date is the "spot" value date — which is two business days after the trade date. Any settlement before the spot date uses a derived price, not a directly traded price.
Gross Settlement vs. Net Settlement
- Gross Settlement: Both counterparties exchange the full value of the currencies on the maturity date
- Net Settlement: Only the difference in value is exchanged, reducing the actual cash flow between parties
The OTC Forward Market
In the OTC forward market, participants can book a forward contract for any maturity period. Key points:
- Liquidity is high for maturities under one year; beyond one year, liquidity drops significantly
- Settlement can be via gross or net settlement
- Important: The OTC forward market requires proof of an underlying trade contract before a forward can be executed — unlike exchange-traded currency futures
Cross Rates in Currency Markets
Sometimes, a direct price for a currency pair is not available in the market. In such cases, the price is calculated by crossing two other available pairs — either by multiplying or dividing the underlying rates. This derived price is known as the cross rate.
Example: If the EUR/USD rate and USD/INR rate are known but EUR/INR is not directly quoted, you first sell INR to buy USD, then sell USD to buy EUR. This two-step conversion gives you the EUR/INR cross rate.
Economic Factors That Impact Currency Prices
The value of any currency at any moment is influenced by a complex set of domestic and global factors. For INR/USD specifically, the key factors include:
Domestic Factors
- GDP growth rate
- Balance of payments and current account deficit (CAD)
- Inflation levels
- Interest rate environment
- Government policies on foreign capital inflows and outflows
Global Factors
- Crude oil prices (critical for India as a net oil importer)
- USD strength against other major currencies
- Geopolitical developments
Key Economic Indicators to Track
| Indicator | What it Measures | Impact on Currency |
|---|---|---|
| GDP | Total market value of all final goods and services produced in a country per year | Higher-than-expected GDP → currency strengthens |
| Retail Sales | Strength of consumer spending (coincident indicator) | Higher retail sales → currency strengthens |
| Consumer Price Index (CPI) | Weighted average of prices for a basket of goods/services; measures inflation | High inflation often weakens the currency |
| Non-Farm Payrolls | Jobs added or lost (excluding farming, government, household, nonprofit) | Strong job growth → currency strengthens |
| Import/Export Data | Trade balance and current account deficit | Widening CAD (more imports) → INR weakens |
| Central Bank Decisions | Interest rate changes, CRR, policy statements | Rate hikes generally strengthen the currency |
Since forex is a global market, analysis cannot be limited to one country. Traders and analysts must also track economic conditions in all major global economies, because the value of INR is always measured against another currency.
Quick Revision: Must-Know Points for the Exam
- Barter → Gold Standard (1870) → Bretton Woods (1944–1971) → Free Float / Managed Float
- USD is the most traded currency; EUR is second; JPY is third
- GBP was the global reference currency until WWII; nickname is "Cable"
- Bid price is always lower and quoted first; offer/ask price is higher and quoted second
- Spot date = trade date + 2 business days
- India's OTC market hours: 9 AM–5 PM; merchants: 9 AM–4:30 PM
- RBI publishes the RBI Reference Rate daily
- OTC forward market requires proof of underlying trade; exchange futures do not
- Cross rate = derived rate calculated by multiplying/dividing two known currency pair rates
- Widening current account deficit → INR weakens
Internal Links
- Chapter 2: Foreign Exchange Derivatives – Forwards, Futures, Options and Swaps
- Chapter 3: Exchange Traded Currency Futures
- Take a Free NISM Series I Mock Test
- Download NISM Series I Study Material
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This is Part 1 of our 7-part NISM Series I Currency Derivatives Short Notes series on PassNISM.in. Bookmark this page and check back for new chapters every week. Good luck with your preparation!