Professional Documents
Culture Documents
Submitted by
Shakti Singh Rathore, 251,DIVC
Chetan Chauhan, 247, DIVC
Rajesh Mishra, 327, DIVD
To
Mr. C.D.Sreedharan
NMIMS, Mumbai
Date: 09/08/2010
FOREIGN E XCHANGE MARKETS
Contents
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The primary purpose of the foreign exchange market is to assist international trade and investment, by
allowing businesses to convert one currency to another currency. For example, it permits a US business
to import British goods and pay Pound Sterling, even though the business's income is in US dollars. It
also supports speculation, and facilitates the carry trade, in which investors borrow low-yielding
currencies and lend (invest in) high-yielding currencies, and which (it has been claimed) may lead to
loss of competitiveness in some countries.
In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a
quantity of another currency. The modern foreign exchange market started forming during the 1970s
when countries gradually switched to floating exchange rates from the previous exchange rate regime,
which remained fixed as per the Bretton Woods system.
§ geographical dispersion
§ continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until
22:00 GMT Friday
§ the low margins of relative profit compared with other markets of fixed income
§ the use of leverage to enhance profit margins with respect to account size
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i) Accounting Convention
India follows a market floating System i.e. the Rs/$ is mainly decided by the forex market.
1. IAS accounting standards given by ICAI such as Inventory valuation, P&L, Cash Flows, FA etc to
ensure that the Accounting practices follow Indian GAAP principles. There are some differences in US
and Indian GAAP like Indian GAAP follows Companies Act1956 in presentation of financial
statements, depreciation calc and in US GAAP such is not followed. US do not follow principle of
conservative reporting as compared to Indian GAAP. Indian GAAP is similar to UK gaap with minute
differences like more standard formats than IAS.
2. XBRL stands for eXtensible Business Reporting Language. It is one of a family of "XML" languages
which is becoming a standard means of communicating information between businesses and on the
internet. Instead of treating financial information as a block of text - as in a standard internet page or a
printed document - it provides an identifying tag for each individual item of data. This is computer
readable. For example, company net profit has its own unique tag. Computers can treat XBRL data
"intelligently": they can recognize the information in a XBRL document, select it, analyze it, store it,
exchange it with other computers and present it automatically in a variety of ways for users. XBRL
greatly increases the speed of handling of financial data, reduces the chance of error and permits
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automatic checking of information. Companies can use XBRL to save costs and streamline their
processes for collecting and reporting financial information. Consumers of financial data, including
investors, analysts, financial institutions and regulators, can receive, find, compare and analyze data
much more rapidly and efficiently if it is in XBRL format. XBRL India is facilitated by the Institute of
Chartered Accountants of India (ICAI). Members of XBRL India among others include regulators such
as Reserve Bank of India (RBI), Insurance Regulatory and Development Authority (IRDA), Securities
and Exchange Board of India (SEBI), Ministry of Corporate Affairs (MCA), stock exchanges like
Bombay Stock Exchange Limited (BSE) and National Stock Exchange of India Limited (NSE), and
some private sector companies.
3. IFRs (International Reporting financial standards). With IFRS companies can gain access to a number
of capital markets around the world. India has announced its intention of moving towards IFRS by 2011.
There are many advantages to stakeholders like economy, industry, investors and accounting
professionals. IFRS provides extensive guidance to revenue, income and financial instruments while
Indian accounting is driven by a standard form.
· Direct Quote: Generally the Direct Quote specifies change in home currency units w.r.t. a fixed foreign
currency. Countries like India, United States and most other countries follow this Quotation.
· Indirect Quote: Indirect Quote on the other hand specifies changes in foreign currency w.r.t fixed home
currency. Countries such as Australia, Britain, and NZ follow the Indirect Quotations.
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i) Mumbai is the Dealing Room location from where the Quote is originated.
iii) SPOT is the type of settlement which happens in T+2 days from the time of execution of the trade.
If today is 30th June 2010, then the value date of the trade happened today on 30th June 2010 is 2nd
July 2010. For e.g. IOB buys dollars from BOI (Buying/selling Banks) then the settlement of this
trade happens in T+2 days format.
v) 46.2125 is the bid rate is the value of the dollars at which the dealer quoting the Quote is ready to
buy the dollar from the Investor. Here 21 is referred to as the point and 25 is called the number of
pips (100 pips=1 point).
vi) 46.2225 is called the Ask Rate is the value of dollar at which the dealer quoting the quote is ready
to sell the dollar to investor. The difference in bid and ask values is referred to a s the ‘bid-ask
spread’.
vii) Trending of Exchange Rate is referred to as the modification of bid-ask spread by the dealer to sell
the currency at the adjusted market price. If the demand of the dollars is less than the dealer lowers
the ask price to say 46.2200 thereby gaining some profit on the trade but less than the earlier trade
of 46.2225.
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viii) Volume Dependency of Bid-Ask Spread. In case the currencies are traded in London where
minimum trading Quantity is 100 million dollars then a dealer can get a large profit even from the
lower bid-ask spread say of 46.2100-46.2200 which is equal to .01000x100 millions of dollars
equal to one Million dollars. While in India minimum trading quantity is $ 1 million, So a dealer
Quoting the bid-ask spread of say of 46.2100-46.2200 will get a profit of 0 .01000x1 millions of
dollars equal to 0.01 Million dollars which is significantly less than the profit made at large
volumes as is the London Case. So IN the Indian market Dealer will find it more profitable to
Quote a wider bid-ask spread to earn more profits while the dealer in London will be satisfied with
the lower bid-ask spread. Hence the Volume of trade affects the Bid-Ask Spread which is high in
India (Low Volume Market) as Compared to Britain (large Volume Market). The low and stable
bid-ask spread in the foreign exchange market, therefore, indicates that market is efficient with
underlying low volatility, high liquidity and less of information asymmetry. The spread in the
Indian foreign exchange market has declined overtime and is very low at present. In India, the
normal spot market quote has a spread of 0.25 of a paisa to 1 paisa, while swap quotes are available
at 1 to 2 paisa spread.
Since London is a high volume market it has a lower bid-ask spread. Here Home Currency pound is the
base currency and UD dollar is the fluctuating currency. Other explanation of the terms in the Quote is
same as for a Direct Quote except that here Home Currency pound is the base currency and UD dollar is
the fluctuating currency. And the Quoting Bank SCBK located in London.
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In payments, nearly 80 clearing and settlement systems, carrying from 500 to over 13 million payments
a day, rely on SWIFT for the secure messaging connectivity and common message standards essential to
their smooth operation.
Financial institutions and regulators continue to seek better control of the risks associated with the
explosive growth in the value of trading. Globally, risk managers are being asked to measure, monitor
and reduce exposure.
In response, industry associations and central banks have developed market infrastructure systems for
the clearing and settlement of high value interbank payments (RTGS – Real Time Gross Settlement
systems) and multi-currency cash payments (CLS – Continuous Link Settlement system), with the
objective of eliminating settlement risk.
The criticality and the multilateral aspect of the payments exchange has positioned SWIFT as a natural
trusted third party that offers secure, reliable and proven messaging services dedicated to the financial
industry. SWIFT is increasingly being used by financial institutions to fill that role.
In parallel, retail payment systems have been built for clearing retail payments such as salaries,
pensions, expenses, and utility bills, within domestic communities.
Under the pressure of the financial industry, these domestic platforms seek volumes to offer scalable
and cost efficient services and to evolve towards regional and international multi-currency platforms.
SWIFT is well positioned to offer the industry cost efficient, reliable and interoperable file transfer
services within communities across countries.
By re-using their existing SWIFT messaging services for retail payments transfer, banks can reduce the
number of channels and reach efficiently retail payments clearing platforms.
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Proven reliability, availability and resilience make SWIFT a first choice when choosing a market
infrastructure provider in both the high value interbank payments and retail payments as well as and
foreign exchange clearing and settlement markets
To facilitate dealings in foreign exchange at bank in India would maintain following accounts with the
banks abroad.
Nostro Account: It is referred to as our Account with you. For e.g. BOI maintains an account with Bank
of America in dollars. When corresponding with Bank of America through its subsidiary in America,
BOI would refer to its account with Bank of America as a Nostro Account.
Vostro Account: It is referred to as your account with us. For e.g. Bank of America maintains a Rupee
account with BOI through its subsidiary IOB in India which is called the Vostro Account.
Loro Account: It is referred to as their Account with you. For e.g. BOI has a dollar Account with Bank
of America. When Union Bank of India wants to refer to its account with BOI through the above
Account of BOI with BOA then in this case BOI’s dollar Account with Bank of America is referred to
as the Loro account.
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E.g. A Company in India does a trade of spices for semiconductors with USA. Assume1$=46Rs.
Suppose a Company imports semiconductors worth $1000 in India from USA. The company in India
will deposit Rupee equivalent amount of 1000US $ i.e. 46000Rs in its bank say BOI. Then these 46000
Rs will be debited from Company’s a/c with BOI through Swift RTGS signal and credited to the vostro
account of BOA (the correspondent bank of BOA in India) with BOI.
At the same time company exports spices worth Rs.46000 from India to USA. The foreign company a/c
with BOA will be debited of $ equivalent of Rs amount i.e. $1000 and credited to Nostro Account of
BOI with BOA in BOI Subsidiary through CHIPS SWIFT signal.
In this way while 46000 Rs are credited to BOA’s vostro a/c with BOI in India, its mirror account is
debited of equivalent $ amount in USA. And while 1000$ are credited to BOI’s nostro a/c with BOA in
USA, its mirror account is debited of equivalent Rupee amount in India.
CHAPS In most countries, high-value or wholesale payments are settled on a Real Time Gross
Settlement (RTGS) basis across accounts held at the central bank: payment instructions are submitted
individually, and the paying bank is debited and the receiving bank is credited before the instruction
continues on to the receiving bank. This means that the receiving bank can then go ahead and credit its
client’s bank account or pay the funds away in the certain knowledge that the original instruction cannot
be revoked. In the technical jargon, ‘receiver risk’ is eliminated. In the UK, CHAPS transfers and
interbank payments in respect of CREST transactions are settled on an RTGS basis. CHAPS is the
same-day electronic funds transfer service, provided by the CHAPS Clearing Company (which is owned
by the commercial banks), that is used for high-value/wholesale payments but also for other time-critical
lower value payments (such as house purchase).
CHAPS payment instructions are routed via the SWIFT network to the RTGS system and settled
individually across the paying and receiving CHAPS banks’ settlement accounts. In a little more detail
(see also diagram overleaf), the message from the sending bank is stored within SWIFT FIN Copy
pending settlement confirmation by the Bank. Meanwhile a message is sent to the Bank from the
SWIFT FIN Copy for settlement. Once the payment is settled in RTGS (sending bank debited, receiving
bank credited), a confirmation is returned to SWIFT and the entire payment message is then forwarded
on to the receiving bank who then processes the payment as required in its own payment systems.
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Finality of the funds transfer between sending and receiving banks is achieved at the moment when the
payment is settled in the books of the Bank.
RTGS: Real time gross settlements. Several emerging markets in recent years have implemented
domestic real time gross
Settlement (RTGS) systems for the settlement of high value and time critical payments to settle the
domestic leg of foreign exchange transactions. Apart from risk reduction, these initiatives enable
participants to actively manage the time at which they irrevocably
Pay away when selling the domestic currency, and reconcile final receipt when purchasing the domestic
currency. Participants, therefore, are able to reduce the duration of the foreign exchange settlement risk.
CHIPS: Clearing House Interbank Payments System. For more than 40 years, CHIPS has set the
industry standard for reliability, efficiency and innovation in wire transfer payments. Leading banks
worldwide, their correspondents and customers rely on CHIPS for real-time payments that are accurate
and final. Today, CHIPS is responsible for over 95% of USD cross-border and nearly half of all
domestic wire transactions totaling $1.5 trillion daily.
CHIPS is operated by The Clearing House, which also provides ACH, paper check exchange and check
image exchange for financial institutions of all sizes.
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2.1. INTRODUCTION
The origin of the foreign exchange market in India could be traced to the year 1978 when banks in India
were permitted to undertake intra-day trade in foreign exchange. However, it was in the 1990s that the
Indian foreign exchange market witnessed far reaching changes along with the shifts in the currency
regime in India. The exchange rate of the rupee, that was pegged earlier was floated partially in March
1992 and fully in March 1993 following the recommendations of the Report of the High Level
Committee on Balance of Payments (Chairman: Dr.C. Rangarajan). The unification of the exchange rate
was instrumental in developing a market-determined exchange rate of the rupee and an important step in
the progress towards current account convertibility, which was achieved in August 1994.
A further impetus to the development of the foreign exchange market in India was provided with the
setting up of an Expert Group on Foreign Exchange Markets in India (Chairman: Shri O.P. Sodhani),
which submitted its report in June 1995. The Group made several recommendations for deepening and
widening of the Indian foreign exchange market. Consequently, beginning from January 1996, wide-
ranging reforms have been undertaken in the Indian foreign exchange market. After almost a decade, an
Internal Technical Group on the Foreign Exchange Market (2005) was constituted to undertake a
comprehensive review of the measures initiated by the Reserve Bank and identify areas for further
liberalization or relaxation of restrictions in a medium-term framework.
The momentous developments over the past few years are reflected in the enhanced risk-bearing
capacity of banks along with rising foreign exchange trading volumes and finer margins. The foreign
exchange market has acquired depth (Reddy, 2005). The conditions in the foreign exchange market have
also generally remained orderly (Reddy, 2006c). While it is not possible for any country to remain
completely unaffected by developments in international markets, India was able to keep the spillover
effect of the Asian crisis to a minimum through constant monitoring and timely action, including
recourse to strong monetary measures, when necessary, to prevent emergence of self fulfilling
speculative activities (Mohan, 2006a).
prevailing rates and the settlement or value date is two business days ahead. The two-day period gives
adequate time for the parties to send instructions to debit and credit the appropriate bank accounts at
home and abroad. The derivatives market encompasses forwards, swaps and options. Though forward
contracts exist for maturities up to one year, majority of forward contracts are for one month, three
months, or six months. Forward contracts for longer periods are not as common because of the
uncertainties involved and related pricing issues. A swap transaction in the foreign exchange market is a
combination of a spot and a forward in the opposite direction. As in the case of other EMEs, the spot
market is the dominant segment of the Indian foreign exchange market. The derivative segment of the
foreign exchange market is assuming significance and the activity in this segment is gradually rising.
Players in the Indian market include (a) ADs, mostly banks who are authorized to deal in foreign
exchange, (b) foreign exchange brokers who act as intermediaries, and (c) customers – individuals,
Corporate, who need foreign exchange for their transactions. Though customers are major players in the
foreign exchange market, for all practical purposes they depend upon ADs and brokers. In the spot
foreign exchange market, foreign exchange transactions were earlier dominated by brokers.
Nevertheless, the situation has changed with the evolving market conditions, as now the transactions are
dominated by ADs. Brokers continue to dominate the derivatives market.
The Reserve Bank intervenes in the market essentially to ensure orderly market conditions. The Reserve
Bank undertakes sales/purchases of foreign currency in periods of excess demand/supply in the market.
Foreign Exchange Dealers’ Association of India (FEDAI) plays a special role in the foreign exchange
market for ensuring smooth and speedy growth of the foreign exchange market in all its aspects. All
ADs are required to become members of the FEDAI and execute an undertaking to the effect that they
would abide by the terms and conditions stipulated by the FEDAI for transacting foreign exchange
business. The FEDAI is also the accrediting authority for the foreign exchange brokers in the interbank
foreign exchange market.
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The liberalization phase was marked by wide ranging reform measures aimed at widening and
deepening the foreign exchange market and liberalization of exchange control regimes. A credible
macroeconomic, structural and stabilization programme encompassing trade, industry, foreign
investment, exchange rate, public finance and the financial sector was put in place creating an
environment conducive for the expansion of trade and investment. It was recognized that trade policies,
exchange rate policies and industrial policies should form part of an integrated policy framework to
improve the overall productivity, competitiveness and efficiency of the economic system, in general,
and the external sector, in particular.
As a stabilsation measure, a two step downward exchange rate adjustment by 9 per cent and 11 per cent
between July 1 and 3, 1991 was resorted to counter the massive drawdown in the foreign exchange
reserves, to instill confidence among investors and to improve domestic competitiveness. A two-step
adjustment of exchange rate in July 1991 effectively brought to close the regime of a pegged exchange
rate. After the Gulf crisis in 1990-91, the broad framework for reforms in the external sector was laid
out in the Report of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan).
Following the recommendations of the Rangarajan Committee to move towards the market-determined
exchange rate, the Liberalized Exchange Rate Management System (LERMS) was put in place in March
1992 initially involving a dual exchange rate system. Under the LERMS, all foreign exchange receipts
on current account transactions (exports, remittances, etc.) were required to be surrendered to the
Authorized Dealers (ADs) in full. The rate of exchange for conversion of 60 per cent of the proceeds of
these transactions was the market rate quoted by the ADs, while the remaining 40 per cent of the
proceeds were converted at the Reserve Bank’s official rate. The ADs, in turn, were required to
surrender these 40 per cent of their purchase of foreign currencies to the Reserve Bank. They were free
to retain the balance 60 per cent of foreign exchange for selling in the free market for permissible
transactions. The LERMS was essentially a transitional mechanism and a downward adjustment in the
official exchange rate took place in early December 1992 and ultimate convergence of the dual rates
was made effective from March 1, 1993, leading to the introduction of a market-determined exchange
rate regime.
The dual exchange rate system was replaced by a unified exchange rate system in March 1993, whereby
all foreign exchange receipts could be converted at market determined exchange rates. On unification of
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the exchange rates, the nominal exchange rate of the rupee against both the US dollar as also against a
basket of currencies got adjusted lower, which almost nullified the impact of the previous inflation
differential. The restrictions on a number of other current account transactions were relaxed. The
unification of the exchange rate of the Indian rupee was an important step towards current account
convertibility, which was finally achieved in August 1994, when India accepted obligations under
Article VIII of the Articles of Agreement of the IMF.
With the rupee becoming fully convertible on all current account transactions, the risk-bearing capacity
of banks increased and foreign exchange trading volumes started rising. This was supplemented by
wide-ranging reforms undertaken by the Reserve Bank in conjunction with the Government to remove
market distortions and deepen the foreign exchange market. The process has been marked by
‘gradualism’ with measures being undertaken after extensive consultations with experts and market
participants. The reform phase began with the Sodhani Committee (1994) which in its report submitted
in 1995 made several recommendations to relax the regulations with a view to vitalizing the foreign
exchange market. Most of the recommendations of the Sodhani Committee relating to the development
of the foreign exchange market were implemented during the latter half of the 1990s.
In addition, several initiatives aimed at dismantling controls and providing an enabling environment to
all entities engaged in foreign exchange transactions have been undertaken since the mid-1990s. The
focus has been on developing the institutional framework and increasing the instruments for effective
functioning, enhancing transparency and liberalizing the conduct of foreign exchange business so as to
move away from micro management of foreign exchange transactions to macro management of foreign
exchange flows.
An Internal Technical Group on the Foreign Exchange Markets (2005) set up by the Reserve Bank made
various recommendations for further liberalization of the extant regulations. Some of the
recommendations such as freedom to cancel and rebook forward contracts of any tenor, delegation of
powers to ADs for grant of permission to corporate to hedge their exposure to commodity price risk in
the international commodity exchanges/markets and extension of the trading hours of the inter-bank
foreign exchange market have since been implemented.
Along with these specific measures aimed at developing the foreign exchange market, measures towards
liberalizing the capital account were also implemented during the last decade, guided to a large extent
since 1997 by the Report of the Committee on Capital Account Convertibility (Chairman: Shri S.S.
Tarapore). Various reform measures since the early 1990s have had a profound effect on the market
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structure, depth, liquidity and efficiency of the Indian foreign exchange market as detailed in the
following section.
Reserve Bank delegated powers to authorized dealers (ADs) to release foreign exchange for a variety of
purposes.
The Foreign Exchange Regulation Act (FERA), 1973 was replaced by the market friendly Foreign
Exchange Management Act (FEMA), 1999. The Reserve Bank delegated powers to authorized dealers
(ADs) to release foreign exchange for a variety of purposes.
CCIL set up under Sodhani Committee: Every eligible foreign exchange contract entered between
members gets notated or replaced by two new contracts – between the CCIL and each of the two parties,
respectively. Following the multilateral netting procedure, the net amount payable to, or receivable
from, the CCIL in each currency is arrived at, member-wise. The Rupee leg is settled through the
members’ current accounts with the Reserve Bank and the USD leg through CCIL’s account with the
settlement bank at New York. The CCIL sets limits for each member bank on the basis of certain
parameters such as member’s credit rating, net worth, asset value and management quality. The CCIL
settled over 900,000 deals for a gross volume of US $ 1,180 billion in 2005-06. The CCIL has
consistently endeavored to add value to the services and has gradually brought the entire gamut of
foreign exchange transactions under its purview. Intermediation, by the CCIL thus, provides its
members the benefits of risk mitigation, improved efficiency, lower operational cost and easier
reconciliation of accounts with correspondents.
An issue related to the guaranteed settlement of transactions by the CCIL has been the extension of this
facility to all forward trades as well. Member banks currently encounter problems in terms of huge
outstanding foreign exchange exposures in their books and this comes in the way of their doing more
trades in the market. Risks on such huge outstanding trades were found to be very high and so were the
capital requirements for supporting such trades. Hence, many member banks have expressed their desire
in several fora that the CCIL should extend its guarantee to these forward trades from the trade date
itself which could lead to significant increase in the liquidity and depth in the forward market. The risks
that banks today carry in their books on account of large outstanding forward positions will also be
significantly reduced (Gopinath, 2005). This has also been one of the recommendations of the
Committee on Fuller Capital Account Convertibility.
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Liberalization Measures
· Authorized dealers were permitted to initiate trading positions, borrow and invest in overseas market,
subject to certain specifications and ratification by respective banks’ Boards. Banks were also
permitted to (i) fix net overnight position limits and gap limits (with the Reserve Bank formally
approving the limits); (ii) determine the interest rates (subject to a ceiling) and maturity period of
FCNR(B) deposits with exemption of inter-bank borrowings from statutory preemptions; and (iii) use
derivative products for asset liability management.
· Participants in the foreign exchange market, including exporters, Indians investing abroad, and FIIs
were permitted to avail forward cover and enter into swap transactions without any limit, subject to
genuine underlying exposure.
· FIIs and NRIs were permitted to trade in exchange traded derivative contracts, subject to certain
conditions.
· Foreign exchange earners were permitted to maintain foreign currency accounts. Residents were
permitted to open such accounts within the general limit of US $ 25,000 per year, which was raised to
US $ 50,000 per year in 2006, has further increased to US $ 1, 00,000 since April 2007.
· The Reserve Bank has been taking initiatives in putting in public domain all data relating to foreign
exchange market transactions and operations. The Reserve Bank disseminates: (a) daily reference rate
which is an indicative rate for market observers through its website, (b) data on exchange rates of rupee
against some major currencies and foreign exchange reserves on a weekly basis in the Weekly
Statistical Supplement (WSS), and (c) data on purchases and sales of foreign currency by the Reserve
Bank in its Monthly Bulletin.
The Reserve Bank has already achieved full disclosure of information pertaining to international
reserves and foreign currency liquidity position under the Special Data Dissemination Standards
(SDDS) of the IMF.
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3.1. INTRODUCTION
Average daily turnover in the five major foreign exchange markets noted earlier increased by 17 per
cent between April and October 2009 to $2.7 trillion (Graph 1). This was the first increase in turnover
since the six months to April 2008 and was broad-based across markets and currency pairs, indicating
the continued importance of global factors.
The rebound in spot and forwards turnover was particularly sharp. One factor driving the rebound in
turnover in these instruments was the recovery in international trade from its crisis-related trough in
early 2009. International trade generates demand for spot and forward foreign exchange because, for
most transactions, one party must exchange their domestic currency for the invoice currency. This can
be undertaken in either the spot market or in the forward market ahead of the invoice payment; the latter
also provides a hedge against subsequent exchange rate movements.
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1. For Spot FX, many electronic communication networks (ECNs) and electronic intermediaries now
exist that combine streaming liquidity from many competing banks to transparently offer their clients
the best market price at any point in time. Indeed, it is not uncommon today for clients to be able to
achieve prices equal to, or better than, the prices that banks themselves are able to achieve on the
interbank market. Many of these ECNs and electronic intermediaries tend to focus on specific market
segments and provide targeted value added services
2. The key economic parameters for most FX contracts are widely understood in common, consistent
terms, and the legal and contractual framework (master agreements, confirmations, etc) within which
contracts are formed is well established. The high degree of standardization however, does not imply
that contracts are in any way limited. FX contracts are as infinitely variable as the specific needs of each
of the multitude of users of the FX market.
- Increased Transparency: Create reports for regulators to have a window into derivative volumes,
unsent/outstanding confirmations and progression on increasing electronification. The reports have been
successfully introduced and are regularly updated.
- Expand the use of electronic confirmation solutions: The London and New
York FX Committee Operation sub-groups are actively promoting greater use of electronic confirmation
solutions through their respective codes of best practice and by engaging with vendors and wider market
participants.
4. Engaging the Buy-Side10: A critical step in reducing confirmation risk within the industry is to
engage further with the buy-side community and encourage new developments (particularly in terms of
electronification of processes for confirmation)
An important means by which counterparty credit risk is managed in the FX market is via the exchange
of collateral between counterparties. This would typically be under an agreement such as the ISDA
Credit Support Annex (CSA). The collateral exchanged may be calculated so as to cover the entire net
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credit exposure between the counterparties, or only the portion of the exposure in excess of a certain
threshold amount, in each case as agreed between the parties. CSAs generally apply across asset classes,
enabling parties to collateralize a single net exposure across their OTC derivatives portfolio. The
collateral process for FX products does not tend to be particularly complex. FX portfolios are usually
relatively straightforward to reconcile and to value, and significant disputes tend to be rare. The issues
that do arise are often due to FX products being commingled in a wider portfolio of products, wherein
there is potential for dispute.
ISDA and the financial industry are currently reviewing the entire process for bilateral collateralization
to improve efficiency and effectiveness, especially in stress scenarios. The main areas being addressed
include:
· Developing standard electronic mechanisms for communicating margin calls and interest payments.
· Achieving more effective and efficient portfolio reconciliation.
· Devising a better, faster process for dispute resolution.
Although much of this work is focused on solving issues that are more prominent in other asset classes
than FX (in particular valuation disputes), the large proportion of FX trading performed within the
ISDA CSA framework means that the FX market will certainly be a beneficiary of any improvements
that are implemented.
Settlement
Arguably the most significant source of systemic risk in the foreign exchange market arises from the
arrangements used to settle foreign exchange trades. FX settlement risk can be defined as the risk that,
having paid away the currency being sold, counterparty defaults and does not pay for the currency
bought. To address this risk, the private sector, with the support of central banks, created CLS Bank
(CLS) which today successfully eliminates settlement risk for over three quarters of inter-dealer trades.
This translates into an average of $3.66 trillion of total value settled per day during June of 2009.11
CLS is a joint initiative between the commercial banks who participate in the service under common
rules and legal commitments. The service is a key part of the FX market infrastructure and settles all the
main FX products; spot, forwards, swaps and NDFs.
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1. Automation has streamlined many transactions and procedures, the foreign exchange market may be
becoming more, rather than less, complex. Given these changes, firms are encouraged to put in place
mechanisms for a continued reassessment of their procedures.
2. The use of electronic interfaces among the dealer/brokering community is encouraged as it reduces
trading- and operations related errors. The introduction of Electronic Communication Networks (ECNs)
and Automated Trading Systems (ATSs)—extending cyber communication from dealers and brokers to
dealers and their customers—will present new challenges to the entire industry.
3. Risk Management
4. There are a variety of documents that ensure the smooth functioning of the markets and protect
participants:
Confirmations reflect economic ties agreed to in a transaction between the parties to a trade. The
agreement covers the significant terms and conditions of the trades (see the 1998 FX and Currency
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Option Definitions, published by the Committee, the International Swaps and Derivatives Association,
and the Emerging Markets Traders Association).
Master Agreements contain terms that will apply to broad classes of transactions, expressions of
market practice and convention, and terms for netting, termination, and liquidation. Other forms of
documentation may include credit support documents, compensation agreements, margin agreements,
and assignment agreements.
2. The growth in electronic trading has also attracted a range of new participants to the foreign exchange
market, from hedge funds to retail investors. In April 2007, around 30 per cent of all turnovers in the
Australian foreign exchange market were conducted through electronic broking systems or electronic
trading systems. Electronic trading has been a major driver of the growth in algorithmic trading by
hedge funds and investment banks. This style of trading is designed to exploit high-frequency
movements in exchange rate quotes that are available electronically, based on a set of pre-defined
trading rules. Major driver of the growth in algorithmic trading by hedge funds and investment banks in
Australia.
3. Derivatives market in India requires include flexibility in the use of various instruments, enhancing the
knowledge and understanding the nature of risk involved in transacting the derivative products,
reviewing the role of underlying in booking forward contracts and guaranteed settlements of forwards.
Besides, market players would need to acquire the necessary expertise to use different kinds of
instruments and manage the risks involved. Options have also been in use in the market for the last four
years. However, their volumes are not significant and bid offer spreads are quite wide, indicating that
the market is relatively illiquid. Another major factor hindering the development of the options market
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is that corporate are not permitted to write/sell options. If corporate with underlying exposures are
permitted to write/sell covered options, this would lead to increase in market volume and liquidity.
Further, very few banks are market makers in this product and many deals are done on a back to back
basis. For the product to reach the farther segment of corporate such as small and medium enterprises
(SME) sector, it is imperative that public sector banks develop the necessary infrastructure and
expertise to transact in options. In view of the growing complexity, diversity and volume of derivatives
used by banks, an Internal Group was constituted by the Reserve Bank to review the existing guidelines
on derivatives and formulate Comprehends. The Australian Derivatives (over-the-counter) market also
expanded, turnover averaging almost US$7 billion per day
forwards. Besides, market players would need to acquire the necessary expertise to use different
kinds of instruments and manage the risks involved. Options have also been in use in the market for
the last four years. However, their volumes are not significant and bid offer spreads are quite wide,
indicating that the market is relatively illiquid. Another major factor hindering the development of
the options market is that corporate are not permitted to write/sell options. If corporate with
underlying exposures are permitted to write/sell covered options, this would lead to increase in
market volume and liquidity. Further, very few banks are market makers in this product and many
deals are done on a back to back basis. For the product to reach the farther segment of corporate
such as small and medium enterprises (SME) sector, it is imperative that public sector banks
develop the necessary infrastructure and expertise to transact in options. In view of the growing
complexity, diversity and volume of derivatives used by banks, an Internal Group was constituted
by the Reserve Bank to review the existing guidelines on derivatives and formulate a policy.
· Systematic Documentation
There are a variety of documents that ensure the smooth functioning of the markets and protect
participants such as Authority Documents, Confirmations related documents, and Master
Agreements and Other forms of documentation may include credit support documents,
compensation agreements, margin agreements, and assignment agreements. These documents can
help significantly to ensure reliability, assurance and efficiency in the forex markets of India. So a
variety of documents to support various trades and transactions will make the Indian Forex Market
more robust and effective in operations.
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4.1. INTRODUCTION
The forward market is that it is a market that deals with forward contracts that sets agreements between
two parties to buy or sell an asset, such as security, at future point in time that is determined on the date
the contract is made.
The forward market would not be what it is without the use of forward contracts. To reiterate, a forward
contract is “an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-
agreed future point in time”. Moreover, there are three specifications of a forward contract:
(3) The exchange rate is fixed at the time the contact is made.
Because of the specifications of a forward contract, the forward market is unique and distinct from
other markets, such as the futures market and the spot market. In addition, the forward market is
selective because it exists in certain nations/countries.
In addition, trading currencies within the forward market is another approach to hedge against the
exchange risk of fluctuating currencies. The forward market consists of four major participants:
arbitrageurs, traders, hedgers, and speculators.
Arbitrageurs
Arbitrageurs enter into the forward market to use forward contracts to eliminate exchange risk involved
in transferring their funds from one nation to another.
Traders
Traders are involved in the forward market to cover the risk of loss on export or import orders that are
denominated in foreign currencies.
Hedgers
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Hedgers are mostly multinational firms that use forward contracts to protect their home currency value
of assets and liabilities that are denominated in a foreign currency; for example, if the U.S. firm bought
a security (an asset) from a Japanese firm through a forward contract, the value of this asset would not
fluctuate on the balance sheet of the U.S. firm despite the fluctuations of the Japanese Yen.
Speculators
Speculators are different from the other participants because of the fact they embrace currency risk.
Speculators are the only ones who expose themselves to currency risk by buying/selling forward
contracts in hopes to profit from exchange fluctuations.
· under flexible exchange rate system and if there are significant exchange variations,
If pound appreciates during the investment period, the foreign investors will reap additional gain in the
change in the exchange rate. However, if pound depreciates, they will experience an exchange loss. The
exchange loss may partially or more than offset the gain in the interest income.
To avoid this exchange loss, dollar investors want cover against the exchange loss by selling pound
forward. The amount of forward pound to sell is equal to the purchase of spot pound plus the interest
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earned in London. This practice is called interest arbitrage. Interest arbitrage links the two national
money markets and the forward market.
Assume: a US investor has a dollars to invest, either in New York or in London. The annual interests in
the US and the UK are 8% and 12%, respectively. The quarterly interest rates in the US and UK are then
2% and 3%, respectively.
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We may enter the forward exchange market. As long as the return from overseas investment is greater
than the domestic return, one would sell forward pound (or whichever currency in question). Only when
the forward transactions are made, the risk can be avoided. However, avoiding the foreign exchange risk
may be too costly, in which case it is not profitable to avoid the risk.
If F = $1.47, then
St=90 = 686.667 x 1.47 < 1.02 million. You are worse off. Even if i* > i, do not invest in the UK. (That
is, taking the foreign exchange risk is cheaper)
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If F = $1.53, then
St=90 = 686.667 x 1.53 >1.02 million. You are better off. Invest in the UK. (In this case, forward
transactions are profitable and eliminate the foreign exchange risk.)
· If one invested A dollars in New York, then at the end of 90 days, the return will be
(1) A (1 + i)
i = i90 = annual interest rate ÷4. However, the subscript 90 is suppressed (too cumbersome)
· If one invested in London (by buying pounds in the spot market, and selling pound forward, the
investor can cover against the exchange risk (interest arbitrage)
Interest arbitrage will cause the forward rate to adjust to the interest rate differential until it reaches an
equilibrium rate. This equilibrium rate F is determined by
F = S (1 + i - i*), or
i - i* = (F - S)/S.
That is, if the domestic interest rate is higher, the forward pound must be sold at a premium.
Specifically, the domestic interest advantage (i - i*) must be equal to %premium on the forward pound
when the forward rate is at its parity. For example, if the domestic interest is 1% above the foreign
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interest rate, forward pound must be higher than the spot rate by the same proportion to prevent
capital flows.
FV=P (1+r)n
For example, if the interest rate in the United States is 5%, then the future value of a dollar in 1 year
would be $1.05.
If the forward exchange rate equalizes the future values of the base and quote currency, then this can
represented in this equation:
Forward Exchange Rate x Future Value of Base Currency = Spot Price x Future Value of Quote
Currency
Dividing both sides by the future value of the base currency yields the following:
S = Spot Price
rq = Interest Rate of Quote Currency
rb = Interest Rate of Base Currency
n = Nu mber of Co mpounding Periods
Forward Exchange Rate = Spot P rice x Future Value of Quote Currency = S (1+ rq ) ^n
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The reason why the forward exchange rate is different from the current exchange rate is because the
interest rates in the countries of the respective currencies is usually different, thus, the future value of an
equivalent amount of 2 currencies will grow at different rates in their country of issue. The forward
exchange rate equalizes the difference in interest rates of the 2 countries. Thus, the forward exchange
rate maintains interest rate parity. A corollary is that if the interest rates of the 2 countries are the
same, then the forward exchange rate is simply equal to the current exchange rate.
Since currency in the country with the higher interest rate will grow faster and because interest rate
parity must be maintained, it follows that the currency with a higher interest rate will trade at a
discount in the FX forward market, and vice versa. So if the currency is at a discount in the forward
market, then you subtract the quoted forward points in pips; otherwise the currency is trading at a
premium in the forward market, so you add them.
In our above example of trading dollars for Euros, the United States has the higher interest rate, so the
dollar will be trading at a discount in the forward market. With a current exchange rate of EUR/USD =
0.7395 and a forward rate of 0.7289, the forward points is equal to 106 pips, which in this case would be
subtracted.
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The most liquid forward contracts are 1 and 2 week, and the 1, 2, 3, and 6 month contracts. Although
forward contracts can be done for any time period, any time period that is not liquid is referred to as a
broken date.
The trader would sell a forward in a tradable currency in exchange for a forward contract in the tradeless
currency. The amount of cash in profit or loss would be determined by the exchange rate at the time of
settlement as compared to the forward rate.
For e.g. consider An investor enters into a forward agreement to purchase a notional amount, N, of the
base currency at the contracted forward rate, F, and would pay NF units of the quoted currency. On the
fixing date, that investor would theoretically be able to sell the notional amount, N, of the base currency
at the prevailing spot rate, S, earning NS units of the quoted currency. Therefore, the profit P, on this
trade in terms of the base currency, is given by:
P= (NS-NF)/S=N*(1-F/S)
NDFs are basically used for hedging against foreign currency exposures and are used by arbitrageurs as
a tool for making profits. E.g. P N Holders and Indian Exporters.
NDFs are primarily used in Singapore and Hong Kong with Dubai and Bahrain showing some activity.
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5. B IBLIOGRAPHY
· www.xbrl.org/in
· http://www.icai.org/
· www.Rbi.org/
· http://www.pwc.com/en_IN/in/assets/pdfs/SDMay2009.pdf
· http://www.rba.gov.au
· http://www.newyorkfed.org
· http://www.bankofengland.co.uk
· http://www.chips.org/
· http://www.swift.com
· Class Notes of C.D. Sreedharan
· Forex Markets by Adhani
· http://en.wikipedia.org
· Intelligence: Individual Interactions Across Cultures. Stanford University Press.
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