Exchange Rates and Forex Business

Module A: International Banking

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Bank Financial Management: Exchange Rates and Forex Business

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Contents
Coverage:
1. Foreign Exchange Definition

and Markets
2. Factors Exchange Rates 3. Exchange Rate Mechanism 4. Foreign Exchange Dealing Room Operations 5. RBI/FEDAI Guidelines
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Determining

1.

FOREIGN EXCHANGE DEFINITION AND MARKETS

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Foreign Exchange- Definition

Conversion of currencies from the currency of invoice to the home currency of the exporters generally required for cross border trade A For Ex Transaction is a contract to exchange funds in one

currency for funds in another currency at an agreed rate and

arranged basis.
All claims payable abroad, whether consisting funds held in foreign currency with banks abroad or bills, checks payable abroad.

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For Ex - FEMA Definition

Foreign Exchange means foreign currency and includes:
i) All deposits, credits and balances payable in foreign currency, and any drafts, travelers cheques, letters of credit and bills of exchange, expressed or drawn in Indian currency and payable in any foreign currency,

ii)

Any instrument payable at the option of the drawee or holder

thereof or any other party thereto, either in Indian currency or in foreign currency, or partly in one and partly in other.

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ForEx Market Participants

Central Banks Commercial Banks Investment funds/banks ForEx brokers Corporations Individuals

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Foreign Exchange Markets

Characteristics: 24 hour market an over the counter market a global market with no barriers/no specific location supports large capital and trade flows highly liquid markets high fluctuations in currency rates settlements affected by time zone factor markets affected by governmental policies and controls
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2.

FACTORS DETERMINING EXCHANGE RATES

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Factors Determining Exchange Rates

Fundamental Reasons
Balance of Payment Economic Growth Rate Fiscal Policy Monetary Policy Interest Rates Political Issues Movement to high yielding currencies Freedom or Restriction of Capital Movement due to Govt. Controls Provides depth and liquidity to the market and acts as a cushion

Technical Reasons

Speculation

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3.

EXCHANGE RATE MECHANISM

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Types of Transactions
Ready/Cash Tom Spot
Settlement of funds on the same day (t+0)

Settlement of funds on the next working day (t+1) Settlement of funds on the second working day (t+2) Delivery of funds on any day after the spot date

Forward
Value date
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Date on which exchange of currencies actually takes place

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Forward Margins Premium and Discounts

Forward Rate = Spot Rate + Premium (or - Discount)
Premium: Forward Value of Currency > Spot Value Discount: Spot Value of Currency > Forward Value

In a perfect market, with no restriction on Finance and Trade, the interest factor is the basic factor in arriving at the forward rate Forward price of a currency can be worked out on the basis of:
Spot price of the currencies involved The interest rate differentials for the currencies The term, i.e., the future period for which the price is worked out
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Type of Quotes
Direct Quote
Foreign currency expressed in terms of home currency (Local Currency is Variable) Also called Home Currency or Price Quotations Ex: USD 1 = Rs. 44.35

Indirect Quote Two-way Quotes

Home currency expressed in terms of foreign currency Ex: Rs. 100 = USD 2.25.

Inter bank quotes

Internationally, all currencies other than GBP, Euro, AUD and NZD are quoted as direct rates.
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Cross Rates
When rates for a particular currency pair are not directly available Ex:
USD/INR Rate is 49.10/11 GBP/USD Rate is 1.5000/10 GBP/INR Rate will be: 49.10 x 1.5000/49.11 x 1.5010

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Fixed vs. Floating Rates

Fixed Rate: Official rate set by the monetary authorities for one or more currencies Floating Rate: Value of the currency decided by supply and demand factors The floating rate system is prevalent in the world market since 1973. India adopted the same in 1993.

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Bid and Offered Rates

Bid rate: Buying Rate Offered Rate: Selling Rate

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Terminology
1 Per Mille: 1 part in every thousand Valuer Compensee payments: Where value date is same in both centers Arbitrage:
Simple/Direct Arbitrage: Between 2 centers only Compound/Three (or more) Point Arbitrage: Where additional centers are involved

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4.

FOREIGN EXCHANGE DEALING ROOM OPERATIONS

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Functions
1. To meet requirements of customers of other

branches/divisions to buy or sell foreign currency. 2. Manage Foreign currency assets and liabilities. 3. Fund and manage Nostro accounts 4. Undertake proprietary trading in currencies.

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3 Parts of a Dealing Room

Front Office

Mid Office

Dealers who are actually involved in buying and selling the currencies, or undertaking market activities.

Compliance of guidelines and instructions. MIS

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Back Office

Dealing Room

Risk Management, and parametrization of Risks for forex dealing operations.

Follow up and Processing/Settlement of deals, Accounts, Reconciliation etc.

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Positions
Funds Position Reflects inflow and outflow of funds i.e. receivables and payables. Mismatches between the two throw open interest rate Risks. Comprises of items that are both ready(immediate effect) and forward in nature Currency Position Deals with overbought or oversold positions. The overall net position exposes the dealer to exchange Risks from market movements.
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Terminology
Exchange Position/Position
The difference between the amount of a currency bought and the amount of the same currency sold is known as position in that currency.

Overbought Position
If the amount of FC bought by a bank is more than the amount sold, the difference between the two is Overbought/Long/Plus position

Oversold Position
If the amount of FC sold by a bank is more than the amount bought, the difference between the two is Oversold/Short/Minus position.

Square Position
If the amount of FC bought by a bank equals the amount sold, then the bank is said to have square position. If there is a small difference, it is known as Near Square position
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Open Position
Exchange position at given point of time

O/N Position
Open Exchange position at the end of the day

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Major Risks associated with ForEx Dealing Operations

Operational Risk Settlement Risk

Exchange Risk

Credit Risk Gap Risk/interest rate Risk Country Risk

Presettlement Risk Market Risk

Liquidity Risk

Legal Risk

Systemic Risk

Sovereign Risk

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5.

RBI/FEDAI GUIDELINES

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Categorisation of Authorised Persons

Cat 1 Authorised Dealer Banks Financial Institutions Other entities permitted to handle all types of ForEx transactions Earlier known as Authorised Dealers Cat 2 Money Changers authorised to undertake sale/purchase of FC notes, travellers cheques, handle FC transactions relating to remittance facilities. Earlier known as Full Fledged Money Changers (FFMCs)
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Cat 3 Allowed to undertake only purchase of FC notes and travellers cheques Earlier known as Restricted Money Changers (RMCs)

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FEDAI Guidelines/Rules
1. 2. Standard transit period for export bills Crystallisation of bills in foreign currency in case of delay in realisation within 60 days 3. 4. 5. 6. Sight bills for Import LC would crystallise on 10th day after date of receipt Forward contracts to have definite amounts and specific delivery dates Delivery period under option contract shall not exceed one month All forward contracts to be automatically cancelled on the 7th working day after maturity if not picked up 7. All cancellation at Banks opposite TT rates

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FEDAI Guidelines/Rules
8. Interest @ 2% above the prime rate of the currency to be charged in event of delay in payment of interbank foreign currency funds 9. Interest @ 2% above the NSE MIBOR to be charged in event of delay in payment of rupee settlement funds 10. All currencies to be quoted as:
Per unit of Foreign currency =INR. Ex: $1 = Rs 45.67 Except JPY, Indonesian Rupaih and Kenyan Schilling. To be quoted as 100 units of Foreign currency = INR.

FEDAI also prescribes code of conduct for FOREX dealers, as also guidelines with regard to dealings with forex brokers.
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RBI Guidelines
Guidelines related to:
Open positions Gaps Borrowing and Lending in Foreign currencies Interbank dealings in India and overseas markets Hedging of banks own exposures as well as that of its resident and non-resident clients

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RBI Guidelines
1. AD CAT 1 Banks allowed to open/close rupee accounts
1. 2. In names of overseas branches or correspondents without prior reference to RBI In names of exchange houses with prior reference to RBI

2. 3.

AD CAT 1 Banks allowed to open/close foreign currency accounts abroad AD CAT 1 Banks can undertake investments in overseas markets in money market instruments and/or debt instruments, issued by foreign state, maturity < 1 yr, rated as per guidelines

4.

Surplus funds in Nostro accounts can be used for

1. 2. Granting Loans to resident constituents Extending credit facilities to Wholly Owned Subsidiaries/JVs of Indian companies abroad

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RBI Guidelines
5. All borrowings in Nostro accounts (including ECB and Temp. Overdraft) not adjusted within 5 days shall not exceed 50% of their unimpaired Tier 1 Capital or USD 10 million whichever is higher 6. Banks can allow banks to book Forward Exchange contracts to hedge their exchange risk exposure
The genuineness of the underlying documentary evidence and exposure must be ascertained

7. 8.

Banks can allow importers/exporters to book Fwd. Contract on basis of declaration of the exposure with limit based on past performance SME customers may be allowed to book forward contracts in alignment with the credit facilities availed by it from the bank

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RBI Guidelines
9. Banks can allow resident individuals to book Forward contracts on deliverable basis with tenors up to 1 year up to a limit of USD $ 100,000. 10. Banks can offer other derivative contracts to resident entities who have borrowed foreign exchange in accordance with the provisions of FEMA 1999 11. Banks can also offer Foreign currency Rupee Swap to resident entities that have a forex or rupee liability to hedge long term exposure 12. Banks can enter into cross currency options and foreign currency-rupee options with their customers on back to back basis

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M S Ahluwalia, amongst other things, is a visual artist, blogger, blog designer and of course an MBA and Banker from New Delhi, India.
To know more about him you may visit his blog-site: Estudiante De La Vida

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