Banking Exchange Rates and Forex Business

CAIIB Super-Notes M S Ahluwalia Sirf Business
Exchange Rates and Forex Business

Module A: International Banking
CAIIB SUPER NOTES
Bank Financial Management: Exchange Rates and Forex 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
FOREIGN EXCHANGE DEFINITION AND MARKETS
1.
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.
(*Defined under FEMA foreign exchange management act, 1999 Section 2)
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.
ForEx Market Participants
Central Banks
Commercial Banks
Investment funds/banks
ForEx brokers
Corporations
Individuals
- Managing their reserves and using currency markets to smoothen out the value of their home currency
- Offering exchange of curriencies to their retail clients and hedging and investing their own assets and
liabilities, as also on behalf of their clients, and also speculating on the movements in the markets
- Moving funds from one country to another using exchange markets as a vehicle for investments as also hedging their
investments in various countries / currencies
- Acting as middleman, between other participants, and at times taking positions on their book
Moving funds between different countries and currencies for investment or trade transactions or
even speculation in currency markets.
Ordinary or high net worth individuals using markets for their investment, trade, personal and travel & tourism needs.
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

FACTORS DETERMINING EXCHANGE RATES
2.
Factors Determining Exchange Rates
Fundamental
Reasons
Fundamental
Reasons
Balance of Payment Balance of Payment
Economic Growth Rate Economic Growth Rate
Fiscal Policy Fiscal Policy
Monetary Policy Monetary Policy
Interest Rates Interest Rates
Political Issues Political 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
Speculation Speculation
Provides depth and
liquidity to the market
and acts as a cushion
Provides depth and
liquidity to the market
and acts as a cushion
The quotation in the FE markets depend on the delivery type of the foreign currency, i. e. excahnge of streams of the two currencies being exchanged.
The spot rates, being the base quotes in the forex markets are more dynamic and are effected by varied reasons. They are as under:
These include all those causes or events, which
affect the basic economic & monetary policies of
the concerned govt. Affects the long term exchange
rates, no effect in the short run
Generally a surplus leads to a raise in imports
while a deficit weakens a currency
A high growth - increase in imports & vice
versa
An expansionary policy, eg: lower taxes can lead
to a higher economic growth
How the central banks attenpts to influence
& control interest and money supply can impact
the value of currency of their country
High domestic interest rates tend to attract overseas
capital, hence
short term gain. however high interest rates slows
down the economy, thus weakening the currency.
Political stability = Economic Stability = Steady
currency & vice versa

can affect exchange rates to a larger extent.

Capital tends to move from lower yielding
currencies, and results, is movement
in exchange rates.
EXCHANGE RATE MECHANISM
3.
Types of Transactions
Settlement of funds on the same day (t+0)
Ready/Cash Ready/Cash
Settlement of funds on the next working day (t+1)
Tom Tom
Settlement of funds on the second working day
(t+2)
Spot Spot
Delivery of funds on any day after the spot date
Forward Forward
Date on which exchange of currencies actually takes place
Value date
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
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 Quote Direct Quote
Home currency expressed in terms of foreign
currency
Ex: Rs. 100 = USD 2.25.
Indirect Quote Indirect Quote
Inter bank quotes
Two-way Quotes Two-way Quotes
Internationally, all currencies other than GBP, Euro, AUD and NZD are quoted as direct rates.
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

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.
Bid and Offered Rates
Bid rate: Buying Rate
Offered Rate: Selling Rate
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
FOREIGN EXCHANGE DEALING ROOM OPERATIONS
4.
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.
3 Parts of a Dealing Room
F
r
o
n
t

O
f
f
i
c
e

F
r
o
n
t

O
f
f
i
c
e

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. M
i
d

O
f
f
i
c
e

M
i
d

O
f
f
i
c
e

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
B
a
c
k

O
f
f
i
c
e

B
a
c
k

O
f
f
i
c
e

Follow up and
Processing/Settlement
of deals, Accounts,
Reconciliation etc.
Follow up and
Processing/Settlement
of deals, Accounts,
Reconciliation etc.
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 Position Funds Position
Deals with overbought or oversold positions.
The overall net position exposes the dealer to exchange Risks
from market movements.
Currency Position Currency Position
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
by a bank is more than the
amount sold, 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
two is
Oversold/Short/Minus
position.
Oversold Position
If the amount of FC sold by
a bank is more than the
amount bought, the
two is
Oversold/Short/Minus
position.
Square Position
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
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
Major Risks associated with ForEx Dealing Operations
Operational
Risk
Operational
Risk
Exchange Risk Exchange Risk Credit Risk Credit Risk
Pre-
settlement
Risk
Pre-
settlement
Risk
Settlement
Risk
Settlement
Risk
Liquidity Risk Liquidity Risk
Gap
Risk/interest
rate Risk
Gap
Risk/interest
rate Risk
Market Risk Market Risk
Legal Risk Legal Risk Systemic Risk Systemic Risk Country Risk Country Risk Sovereign Risk Sovereign Risk
RBI/FEDAI GUIDELINES
5.
Categorisation of Authorised Persons
Cat 1 Cat 1
Authorised Dealer
Banks
Financial
Institutions
Other entities
permitted to
handle all types of
ForEx transactions
Earlier known as
Authorised Dealers
Cat 2 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)
Cat 3 Cat 3
Allowed to
undertake only
purchase of FC
notes and
travellers cheques
Earlier known as
Restricted Money
Changers (RMCs)
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 10
th
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 7
th
working
day after maturity if not picked up
7. All cancellation at Banks opposite TT rates
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.
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
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

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

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
Do you have any questions or queries or some feedback to give?

Just mark an email to super.msahluwalia@yahoo.com
For more Super-Notes: Click Here
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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