Foreign Exchange Market

Foreign Exchange Market
By
Rajeev Kumar Jha
Treasury Department
Chinatrust Commercial Bank Ltd., New Delhi Branch

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

Structure of the Presentation
Basic Concepts, Terminologies, Instruments & Mechanism.
Exchange Rate Regimes
Historical perspective
Foreign Exchange Trading & rate quotations
Role of Reserve Bank of India (RBI) in the FX Market.

As per Foreign Exchange Act, (Section 2), 1947.
(c) "Foreign Currency" means any currency other than Indian currency;
(d) "Foreign Exchange" means includes any instrument drawn, accepted, made or issued under clause (8) of section 17 of the Banking Regulation Act, 1956, all deposits, credits and balance payable in any foreign currency, and any drafts, traveler’s cheques, letters of credit and bills of exchange, expressed or drawn in Indian currency but payable in any foreign currency;
BASIC CONCEPTS/TERMINOLOGIES Foreign Currency vs. Foreign Exchange

Financial Markets
Financial market is a place where Resources/funds are transferred from those having surplus/excess to those having a deficit/shortage.

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. 48.50 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 Scheduled Commercial Banks
(Authorized Dealers only).
Reserve Bank of India (RBI).
Corporate Treasuries.
Public Sector/Government.
Inter Bank Brokerage Houses.
Resident Indians
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/INR)
‘Dealt’ or ‘Variable’ Currency
Exchange Rate
Amount
Deal Date
Value Date
Settlement Instructions

Value Date Conventions
Currencies are traded both in Ready and forward value dates .
1) Ready: Settlement on the deal date. e.g. India
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/INR= 48.50 / 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/INR= 48.50/60

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’.

RATE QUOTATION CONVENTIONS
IN-DIRECT QUOTATION:
“ Price of one Unit of Foreign Currency in terms of Domestic Currency”
e.g. USD/INR = 48.50/60
Buy One USD at 48.50
Sell One USD at 48.60
Spread 00.10
In the international market, almost all currencies are quoted indirectly.

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) Pound Sterling
2) Euro
3) Australian Dollar
4) New Zealand Dollar
5) Irish Punt

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
Out right sale/purchase of a currency against the other for settlement at a future date at the predetermined exchange rate.
Forward rates are quoted as premium or discount over spot rate.
Forward rates depend upon interest rate differential between the two currencies.
Currency with higher interest rates is at discount wrt currency having lower interest rate.
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 INR = 6.00% Spot Rate = 48.50 DB for INR = Actual/365 DB for USD = Actual/360 Six month Forward Rate = spot rate (48.50) 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. Reserve Bank of India (RBI) 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 Reserve Bank of India (RBI).
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.
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 Reserve Bank of India (RBI) pages on REUTERS.

Pre-Reform era till early 90s ( The fixed ERM & Exchange Control Regime)
Fixed ERM, with occasional devaluations.
Reserve Bank of India (RBI) 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)
Reserve Bank of India (RBI) to buy and sell forex from and to ADs, at its buying and selling rates for Authorized Dealers.
Reserve Bank of India (RBI) 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 Reserve Bank of India (RBI).
Elaborate system of reporting by ADs to Reserve Bank of India (RBI).

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 Reserve Bank of India (RBI) .
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, India was making gradual moves towards market based ERM.
Third currency rates to be quoted by banks.
Reserve Bank of India (RBI) also stopped giving customer’s 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.

Detonation of May 98 changed the way things were moving.
Despite low reserves, Reserve Bank of India (RBI) 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

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 India.
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.
Any sale or purchase of foreign currency entails foreign exchange risk.
Foreign exchange transaction affects the net asset or net liability position of the buyer/seller.
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 INR
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 Reserve Bank of India (RBI) and linkages with economy

RBI’s 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.

RBI 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.
RBI’s Role in the Forex Market

TREASURY OPERATIONS AT RBI
All Central Banks have treasuries to implement policy objectives vis a vis EXCHANGE RATE & INTEREST RATES
Dealing room catered to the FX market only
Money market was being looked after by the Securities department
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
Finally the dealing room and securities department were merged to form EDMD to from first ever Treasury of RBI.

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 feedback 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 – M2M, 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 RBI 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 RBI 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 RBI
Reports from CRS
Exposure Report
FE - 25 balances & other deposits
Nostro Balances
Un-reconciled interbank deals

Off Site monitoring of banks by RBI
Reports from CRS Cont’d
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 RBI 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 10 % of it’s 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 RBI 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 RBI only indirectly intervenes in the market.
RESERVE BUILDING

Thank You

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Foreign Exchange Market

by rajeevj on Dec 27, 2008

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