Local Foreign Exchange Market

2
A Comment

There is no sphere of human influence in which
it is easier to show superficial cleverness and the
appearance of superior wisdom as in matters of
currency and exchange
Winston Churchill
House of Commons 1946
3
Structure of the Presentation
Basic Concepts, Terminologies, Instruments &
Mechanism.
Exchange Rate Regimes
Historical perspective
Foreign Exchange Trading & rate quotations
Role of SBP in the FX Market.
As per Foreign Exchange Act, (Section 2), 1947.

(c) "Foreign Currency" means any currency other than
Pakistan currency;

(d) "Foreign Exchange" means includes any instrument
drawn, accepted, made or issued under clause (8) of section 17
of the State Bank of Pakistan Act, 1956, all deposits, credits
and balance payable in any foreign currency, and any drafts,
travelers cheques, letters of credit and bills of exchange,
expressed or drawn in Pakistan currency but payable in any
foreign currency;
BASIC CONCEPTS/TERMINOLOGIES
Foreign Currency v/s Foreign Exchange
5
Financial Markets
Financial market is a place where
Resources/funds are transferred from those
having surplus/excess to those having a
deficit/shortage.
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Foreign Exchange Markets
The market where the commodity traded is
Currencies.
Price of each currency is determined in term of
other currencies.
Exchange Rate is the price of one country's currency
expressed in another country's currency. In other words,
the rate at which one currency can be exchanged for
another.
e.g. Rs. 85.50 per one USD

Major currencies of the World

USD
EURO
YEN
POUND STERLING
What is an Exchange Rate ?
What is a Foreign Exchange Transaction ?

Any financial transaction that involves more than one
currency is a foreign exchange transaction.
Most important characteristic of a foreign exchange
transaction is that it involves Foreign Exchange Risk.
PARTICIPANTS IN THE FOREIGN
EXCHANGE MARKET
All Commercial Banks
(Authorized Dealers only).
State Bank of Pakistan.
Corporate Treasuries.
Public Sector/Government.
Inter Bank Brokerage Houses.
Resident Pakistanis
Non Residents
Exchange Companies
Money Changers
FIXED
PEGGED
COMPOSITE
MANAGED FLOAT
FREE FLOATING

FOREIGN EXCHANGE REGIMES
Components of a Standard
FX Transaction
Base Currency (USD/PKR)
Dealt or Variable Currency
Exchange Rate
Amount
Deal Date
Value Date
Settlement Instructions

12

Value Date Conventions

Currencies are traded both in Ready and forward
value dates.

1) Ready: Settlement on the deal date. e.g. Pakistan

2) Value Tom : Settlement on next day. e.g. Canada

3) Spot Transaction : settlement usually in two working days.
In international FX transactions, Spot is the Standard value date.

Why Spot Date ?

Time Zone Difference
Herstat Risk

4) Forward Transaction: Settlement at some future date ahead of
the spot.


FX Rate Quotation:

In the forex market rates are always quoted two way.
Two way quote gives both Bid and Offer.

e.g.
USD/PKR= 85.50 / 60
Bid / Offer

Big Figure: Term referring to the first digits of an exchange rate. These figures are rarely change in normal
market fluctuations and are usually omitted in dealer quotes.

Pips (or Point): The smallest incremental move an exchange rate can make.


Base Currency Vs. Dealt Currency

Number of variable or dealt currency unit in one unit of base currency.

In international quotes base currency comes first.
e.g. BC/VC
USD/PKR= 85.55/60

Price maker Vs. Price Taker

The bank quoting the price is price maker or
market maker.

The bank asking for the price or quote is the
price taker or user.
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RATE QUOTATION CONVENTIONS

IN-DIRECT QUOTATION:

Price of one Unit of Foreign Currency in terms of
Domestic Currency

e.g. USD/PKR = 85.45/50

Buy One USD at 85.45
Sell One USD at 85.50
Spread 00.05

In the international market, almost all currencies are
quoted indirectly.


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RATE QUOTATION CONVENTIONS
DIRECT QUOTATION:

Price of one Unit of Domestic Currency in terms of Foreign Currency

e.g. EURO= 1.2805/12

Buy One Euro at 1.2805
Sell One Euro at 1.2812
Spread 0.0007

Five Currencies are quoted in Direct Terms

1) Euro
2) Pound Sterling
3) Australian Dollar
4) New Zealand Dollar

In the international market, almost all the
currencies are quoted in terms of USD.
e.g.
JPY= 105.78/82
A visit to REUTERS EFX= Page.


FORWARD TRANSACTIONS

1. Out right sale/purchase of a currency against the other
for settlement at a future date at the predetermined
exchange rate.

2. Forward rates are quoted as premium or discount over
spot rate.

3. Forward rates depend upon interest rate differential
between the two currencies.

4. Currency with higher interest rates is at discount wrt
currency having lower interest rate.

5. Currency with lower interest rates is at premium wrt
currency having higher interest rate.
Calculating Forward Rate


Interest rate of USD = 1.25%
Interest rate of PKR = 6%
Spot Rate = 58.50
DB for PKR = Actual/365
DB for USD = Actual/360

Six month Forward Rate =
spot rate x (1+ .06*181/365)/(1+.0125*181/360)
=59.87
FX SWAP Transaction

An FX swap is a contract to buy an amount of
currency for one value date at an agreed rate, and
to simultaneously resell the same amount of
currency for a later value date, also at an agreed
rate, to the same counter party.

FX swap is essentially a funding or Money
Market transaction and does not involve exchange
risk.

Foreign exchange transactions are settled through Nostro and
Vostro accounts.

Nostro: our account with banks abroad. SBP maintains various
Nostro accounts in a number of countries.
Vostro: their account with us. Many multilateral agencies (e.g.
IMF, World Bank) maintain their Nostro accounts at SBP.

SWIFT (Society for Worldwide Interbank Financial
Telecommunications)

Deals are done over Telephone, REUTERS
dealing system etc
R E U T E R S
Dealing Terminal
Industry Standard for FX trading.
Security guaranteed by Reuters Int.
Password Protected.
Maintains record of all transactions.
SBPK (SBPs REUTERS address)

News Terminal
Domestic Market Data/ news available on line.
Real Time Exchange Rate quotes of all major Currencies.
Data about Interest Rates (e.g. LIBOR)
Various SBP pages on REUTERS.
Pre-Reform era till early 90s ( The fixed ERM &
Exchange Control Regime)
Fixed ERM, with occasional devaluations.
SBP to fix its buying & selling rates for Authorized Dealers
and their rates for customers.
Residents not allowed to hold foreign exchange.
Only ADs (Banks), allowed to deal in Fx.
Fx available only for current account transactions. (goods &
services) and some other personal transactions viz. travel,
education, medical treatment etc.
Pre-Reform era till early 90s
(The fixed ERM & Exchange Control Regime)
SBP to buy and sell forex from and to ADs, at its
buying and selling rates for Authorized Dealers.
SBP to provide forward cover to ADs for importers
and exporters as well as foreign currency loans
mobilized by corporates from abroad.
Exporters of goods and services, were bound to sell
forex to an AD at rates prescribed by SBP.
Elaborate system of reporting by ADs to SBP.
Market liberalization. The decade of 90s

Early nineties marked an era of liberalization of foreign
exchange market.
FCAs Scheme was launched for Resident Pakistanis.
Banks were required to surrender their FC deposits
against purchase of forward cover from SBP.
Money Changers were authorized to Deal in foreign
exchange (Notes and TCs only).
Forward cover for imports and exports shifted to banks.
Forward cover for FC loans also transferred to banks
(under certain rules and regulations).
Post detonation crisis (May 98) and move
towards market based ERM.
In early 98, Pakistan was making gradual moves
towards market based ERM.
Third currency rates to be quoted by banks.
SBP also stopped giving customers buying
and selling rate and gave a 1% band to the
market, quoting its buying and selling rates for
ADs.
The target was to put the currency on free float.

Post detonation crisis (May 98) and move
towards market based ERM.
Detonation of May 98 changed the way things were
moving.
Despite low reserves, SBP made the decision of going
ahead with fx market reforms.
Phased approach was adopted for transition to free
float.
As a first step Two-Tier ERM was introduced in July 21,
1998.
Except for essential items (e.g. wheat l/cs) , the rest of
the trade transactions were settled through interbank
market.
Initially 50/50 , 80/20, FINALLY 95/05

Post detonation crisis (May 98) and
move towards market based ERM.
Two-tier was finally abolished in May 1999.
Currency was freely floated.
Regulations pertaining to current account
transactions remained more or less unchanged.
However all transactions were to be done at
interbank rate and every bank was to offer its own
rate to customers.
However, an unofficial narrow band was imposed on
banks, which remained there till July 2000. when it
was finally done away with.
The Demand Side of inter-bank market
importers buying foreign exchange to finance
their imports.
A host of regulations governing imports into
Pakistan.
Out ward remittances for debt servicing.
Out ward remittances for services.
PTEQ and BTQ, Medical treatment etc.
Forex Transactions
Forex Transactions

The Demand Side of inter-bank market
Remittances on account of education abroad.
Remittances on account medical treatment.
Repatriation of profit of foreign controlled
companies and freight collection etc.
Disinvestment through SCRA.
A host of other invisible payments.
The Supply Side of inter-bank market
Exports regulations governing export receipts.
Home remittances.
Foreign Direct Investment.
Capital account receipts.
Investment through SCRA.
A host of other invisible receipts.
Forex Transactions
Foreign Exchange Risk

Exposure to exchange rate movement.
1. Any sale or purchase of foreign currency entails
foreign exchange risk.
2. Foreign exchange transaction affects the net
asset or net liability position of the buyer/seller.
3. Carrying net assets or net liability position in any
currency gives rise to exchange risk.
NET OPEN POSITION- (NOP)
A measure of foreign exchange risk

NOP is the Net Asset/Net Liability position in all
FCs together (Both B/S & Off B/S).
Net Asset Position is also called LONG or
Overbought position.
Net liability Position is also called SHORT or
Oversold position.
NOP is a single statistic that provides a fairly
good idea about exchange risk assumed by the
bank.
Its major flaw is that FX exposures in third
currencies remain hidden.


EXAMPLE (NOP) (USD in Mio)

Opening Position $ 0.00

Ready Purchases from Exporter $ 1.00

Fwd Purchases from Corporate (1.00 Euro) \ $ 0.90

Ready Sell to importer ( 60 Mio Yen) - $ 0.50

Fwd Sell to Corporate - $ 0.40

NET OPEN POSITION $ 1.00

Foreign Exchange Exposure
FX Exposure is the higher of the long and short positions in
FCs.

EXAMPLE
Currency-wise NOP in equivalent PKR

CURRENCY SHORT LONG
Dollar -10
Yen 10
Euro -10
Pound 10
Total -20 20
Net Open Position is 0 while exposure is 20.


Introduction to Inter-bank FX activities
Foreign Exchange Markets

Role of SBP and linkages
with economy
SBPs Role in the Forex Market
To manage the exchange rate mechanism.

Regulate inter-bank forex transactions and monitor
the foreign exchange risk of the banks.

Keep the exchange rate stable.
Manage and maintain country's foreign exchange
reserves.
SBP has imposed foreign exchange
exposure limits on banks (FE 12 of 1999).
The limits are tied with the Paid up capital
of the bank.
Previously banks had NOP limit, which was
based on foreign exchange volume
handled by the bank.
SBPs Role in the Forex Market
TREASURY OPERATIONS AT SBP

1. All Central Banks have treasuries to implement policy
objectives vis a vis EXCHANGE RATE & INTEREST
RATES
2. Dealing room catered to the FX market only
3. Money market was being looked after by the Securities
department
4. It soon became apparent that the two cannot work in
isolation with each other as the linkage between the
money market & exchange market became pronounced
5. Finally the dealing room and securities department were
merged to form EDMD to from first ever Treasury of
SBP.

Functions of DMMD
Market Monitoring
Pro active monitoring of interbank MM & FX
market by Front Office.
Prepare demand/supply forecast.
Gather data from various Sources.
Real time feedbck to management.
Real time remedial measures to remove
distortions in the market.

A day in the Front Office
NOP report.
FX inflow/outflow statements.
Oil payments,
Forward transactions.
Market monitoring Market Flows and their impact
on exchange rate.
Money Market liquidity
Forward rates
Market activity if required
Rates Preparation M 2 M, Wtd Avg, FCA
Conversion.
Front Office Challenges
Small Market Size
Lumpy payments
Leads and Lags.
Historical trend of keeping long positions.
The issue of entries in transit.

INTERVENTION
To keep exchange rate in line with macro
objectives SBP has to intervene from time
to time
Intervention is a process where FX is sold
or purchased to keep the right amount of
liquidity available in the FX market so that
demand / supply equilibrium is maintained
Intervention can be in READY or
FORWARD

OTHER FX RELATED FUNCTIONS

OFFSITE MONITORING
DAILY RATES FOR MARKET
THIRD CURRENCY ACTIVITY FOR GoP
PAYMENTS
RESERVE MANAGEMENT

Off Site monitoring of banks by SBP
Inputs of Computerized
Reporting System (CRS)
All individual foreign exchange transactions reported
by each bank on daily basis on a floppy diskette
Amount
Type of Deal
Counter Party
Currency
Rate
Posting date
Maturity Date
Deal Date
Mode of Deal
Off Site monitoring of banks by SBP
Reports from CRS
Exposure Report
FE - 25 balances & other deposits
Nostro Balances
Un-reconciled interbank deals
Off Site monitoring of banks by SBP
Reports from CRS Contd
Reports for research & statistical purposes
Business volume - banks/customers/currency
Types of transactions/customers/currency
Broker wise market volume report
History of exchange rates - trend analysis
How does SBP manages exchange
rate in the interbank market?
Non-Quantitative Tools
Quantitative Tools
Non-Quantitative Tools



Moral suasion
facilitating large commercial outflows
Relaxation in FEEL


Quantitative Measures
Foreign Exchange Exposure Limit (FEEL)
Basically restricts the banks to keep a net asset (long)
or net liability (short) position in foreign currencies.
Presently FEEL for each bank is set at 15 % of its paid
up capital.
In the presence of FEEL, banks net purchases or net
sales in foreign exchange on a given day have to be
within their FEEL.
How does SBP manages exchange
rate in the interbank market?
Physical intervention

Direct selling or buying of foreign exchange by
State Bank in the interbank market.
Such sale/purchase can be in spot or forward value
It can have two objectives
To provide support to the market for
lumpy payments
To manage the Rs/$ parity

Intervention may be direct or indirect. Currently
SBP only indirectly intervenes in the market.

RESERVE BUILDING

Thank You