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1. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Exchange Rates and Forex Business
Module A: International Banking

2. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
CAIIB – SUPER NOTES
Bank Financial Management: Exchange Rates and Forex Business

3. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Contents
Coverage:
1. Foreign Exchange – Definition
and Markets
2. Factors Determining
Exchange Rates
3. Exchange Rate Mechanism
4. Foreign Exchange Dealing
Room Operations
5. RBI/FEDAI Guidelines

4. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
FOREIGN EXCHANGE – DEFINITION AND MARKETS
1.

5. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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.

6. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
For Ex - FEMA Definition
Foreign Exchange means foreign currency and includes:
i) All deposits, credits and balances payable in foreign currency, and
any drafts, traveler’s 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.

7. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
ForEx Market Participants
• Central Banks
• Commercial Banks
• Investment funds/banks
• ForEx brokers
• Corporations
• Individuals

8. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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

9. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
FACTORS DETERMINING EXCHANGE RATES
2.

10. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Factors Determining Exchange Rates
Fundamental
Reasons
Fundamental
Reasons
Balance of PaymentBalance of Payment
Economic Growth RateEconomic Growth Rate
Fiscal PolicyFiscal Policy
Monetary PolicyMonetary Policy
Interest RatesInterest Rates
Political IssuesPolitical Issues
Technical
Reasons
Technical
Reasons
Freedom or Restriction
of Capital Movement
due to Govt. Controls
Freedom or Restriction
of Capital Movement
due to Govt. Controls
Movement to high
yielding currencies
Movement to high
yielding currencies
SpeculationSpeculation
Provides depth and
liquidity to the market
and acts as a cushion
Provides depth and
liquidity to the market
and acts as a cushion

11. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
EXCHANGE RATE MECHANISM
3.

12. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Types of Transactions
• Settlement of funds on the same day (t+0)Ready/CashReady/Cash
• Settlement of funds on the next working day (t+1)TomTom
• Settlement of funds on the second working day
(t+2)SpotSpot
• Delivery of funds on any day after the spot dateForwardForward
• Date on which exchange of currencies actually takes placeValue date

13. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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

14. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Type of Quotes
• 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
Direct QuoteDirect Quote
• Home currency expressed in terms of foreign
currency
• Ex: Rs. 100 = USD 2.25.
Indirect QuoteIndirect Quote
• Inter bank quotesTwo-way QuotesTwo-way Quotes
Internationally, all currencies other than GBP, Euro, AUD and NZD are quoted as direct rates.

15. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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

16. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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.

17. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Bid and Offered Rates
• Bid rate: Buying Rate
• Offered Rate: Selling Rate

18. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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

19. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
FOREIGN EXCHANGE DEALING ROOM OPERATIONS
4.

20. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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.

21. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
3 Parts of a Dealing RoomFrontOfficeFrontOffice
Dealing Room
Dealers who are
actually involved in
buying and selling the
currencies, or
undertaking market
activities.
Dealing Room
Dealers who are
actually involved in
buying and selling the
currencies, or
undertaking market
activities.
MidOfficeMidOffice
Risk Management,
and parametrization
of Risks for forex
dealing operations.
Compliance of
guidelines and
instructions.
MIS
Risk Management,
and parametrization
of Risks for forex
dealing operations.
Compliance of
guidelines and
instructions.
MIS
BackOfficeBackOffice
Follow up and
Processing/Settlement
of deals, Accounts,
Reconciliation etc.
Follow up and
Processing/Settlement
of deals, Accounts,
Reconciliation etc.

22. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Positions
• 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
Funds PositionFunds Position
• Deals with overbought or oversold positions.
• The overall net position exposes the dealer to exchange Risks
from market movements.
Currency PositionCurrency Position

23. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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.
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
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.
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”
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”
Open Position
• Exchange position at given
point of time
Open Position
• Exchange position at given
point of time
O/N Position
• Open Exchange position at
the end of the day
O/N Position
• Open Exchange position at
the end of the day

24. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Major Risks associated with ForEx Dealing Operations
Operational
Risk
Operational
Risk
Exchange RiskExchange Risk Credit RiskCredit Risk
Pre-
settlement
Risk
Pre-
settlement
Risk
Settlement
Risk
Settlement
Risk
Liquidity RiskLiquidity Risk
Gap
Risk/interest
rate Risk
Gap
Risk/interest
rate Risk
Market RiskMarket Risk
Legal RiskLegal Risk Systemic RiskSystemic Risk Country RiskCountry Risk Sovereign RiskSovereign Risk

25. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
RBI/FEDAI GUIDELINES
5.

26. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Categorisation of Authorised Persons
Cat 1Cat 1
• Authorised Dealer
Banks
• Financial
Institutions
• Other entities
permitted to
handle all types of
ForEx transactions
• Earlier known as
Authorised Dealers
Cat 2Cat 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)
Cat 3Cat 3
• Allowed to
undertake only
purchase of FC
notes and
traveller’s cheques
• Earlier known as
Restricted Money
Changers (RMCs)

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

28. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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.

29. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
RBI Guidelines
• Guidelines related to:
– Open positions
– Gaps
– Borrowing and Lending in Foreign currencies
– Interbank dealings in India and overseas markets
– Hedging of bank’s own exposures as well as that of its resident and
non-resident clients

30. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
RBI Guidelines
1. AD CAT 1 Banks allowed to open/close rupee accounts
1. In names of overseas branches or correspondents without prior reference to RBI
2. In names of exchange houses with prior reference to RBI
2. AD CAT 1 Banks allowed to open/close foreign currency accounts abroad
3. 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. Granting Loans to resident constituents
2. Extending credit facilities to Wholly Owned Subsidiaries/JVs of Indian companies
abroad

31. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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. Banks can allow importers/exporters to book Fwd. Contract on basis of
declaration of the exposure with limit based on past performance
8. SME customers may be allowed to book forward contracts in alignment with
the credit facilities availed by it from the bank

32. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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

33. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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34. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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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