Understanding

Foreign Exchange
MT380 & MT304

By
Mohammed
Naseeruddin
What is Foreign Exchange ?

 It refers to buying the currency of one country, while selling the

currency of another country.

 The Forex market is the 24 hours cash market where

currencies are traded , typically via broker.

 Unlike other financial markets, Forex market has no physical

location and no central exchange . It is world wide
decentralized over the counter market (OTC).

 Traders communicate with each other via internet intranet

telephone and other electronic media.

 Role of a SWIFT : It is an important mode of Communication/

messaging in Forex market e.g MT380, MT304 etc.
 Forex quotation

 Forex quotation : USD/ INR 64.2332/64.2336

 Base currency : currency to the left
 Qoute/ counter currency : currency to the right
 Bid rate/Price : 64.23 (Price at which Forex dealer will buy the base
currency , bid is always smaller then ask) .
 ASK rate/price : 64.26 (price for which Forex dealer will sell the base
currency .
 Pips : one point movement in exchange rate . In the above example if
the exchange rate moves from 64.2332 to 64.2333 would be called as
pips .
 Spread : It’s a difference between BID and ask rate . 64.2336-64.2332
= 0.0004
What does money transfer in practice mean ?

 Money transfer literally would mean exchange of currency .

But in practice very small percentage of money is held as cash
.Most of the liquid money is held trough “ current account “ in
the banks. hence to transfer money it would be rare that people
withdraw cash from the banks and exchange it .Current account
deposits are also called as demand deposits. Hence payment
in practice would be effected trough a transfer of ownership of
demand deposits from payer to payee and this is done by
sending instruction orders, phone, wire transfer or internet
networks.
Correspondent bank

 If the Indian company has to make payment in US dollars

to one supplier and in Japanese currency (JPY) to another,
then probably it has to maintain deposits in US and Japan and
issue a check/instruction for transfer of money to the supplier .
It is rather impractical to maintain account in each of the
currency one deals with. To ease the situation , all major banks
maintain accounts in another banks in different countries. The
bank in which another bank maintain an account is called as “
Correspondent bank” of the depositors bank.
Example:
 Buyer A from India purchases material from supplier B in the
United States. The material is worth US$ 100. Prevailing
exchange rate is 1US$= RS. 46. Buyer A maintain accounts
with Indian bank SBI in Indian rupee. SBI maintain US dollar
accounts with its “correspondent bank” BONY( Bank of NEW
York) .Seller B has current account with BoNY. To effect the
payment buyer A instruct SBI to debit its account equivalent to
US$100, in effect SBI issue an instruction to BoNY to debit its
(SBI’s) account by US$100 and credit seller B ‘s account with
the same amount.
Nostro, Vostro, Loro

 Banks maintain correspondent banking-relations with banks in

other countries, they would obviously prefer to maintain it with
those countries bank with whom their customer have significant
trade volume. This is because maintaining such account in
another bank abroad cost fees for the bookkeeping chores
performed. The accounts held by a bank abroad are called
Nostro accounts, Vostro accounts , or Loro accounts.
 Nostro : Domestic bank’s account held with a foreign bank.
 Vostro : Foreign bank’s account with domestic bank.
 Loro : Third party account.
 Exchange Rate

 Currency like any other traded goods, has a price . This price
can undergo dramatic changes over a shorts periods of time.
There are two main types of exchange rate systems viz , fixed
and floating .
 In case of fixed exchanged rate system , the government of that
country decides a specific ratio of its currency with another
currency. E.G China maintained a fixed peg (ration) with US
dollar till year 2005 as 1 USD = 8 Chinese Yuan.
 In floating exchange rate system, the Govt doesn't dictate any
rate. Its purely driven by the demand supply factors in the
market of the two currencies.
Devaluation vs. Revaluation

 Devaluation : In simple terms when the citizens have to pay more of

their home currency to buy a foreign currency (due to change of
exchange rate by the government ), then it is called as Devaluation.
e.g. suppose 64.50INR = 1 USD
Later it was changed to 65.50 INR= 1 USD
So value of Indian rupee has gone down , Indian Rupee is devalued.
Motives of Devaluation :
1) To increase export.
2) To reduce loss of foreign exchange reserve.
3) To maintain stable Balance of payment.

Revaluation : Revaluation is opposite of devaluation.

 Types of FX’s from investment managers perspective

 Foreign exchange order (MT380)  3rd party FX (MT304) :

/Direct FX : Where IM directly  Foreign exchange transaction sent
contact or sends the instruction to by the IM/ Client which is executed
JP Morgan to execute the FX, since by the a broker, dealer, forex
JP morgan holds the custody institution , bank, financial
account of its clients . FX instruction institution other than JP Morgan
can come through FAX, TI , swift . Key elements in MT304
Key elements in MT380
 Clients account
 Clients account :
 Executing Broker
 Amount (buy or Sell)
 FX rate/ price
 Buy Currency & Sell Currency
 Amount bought
 Trade date
 Amount sold
 Value date
 Currency bought
 Further IM can send the FX through
MT54X linked with the trade(  Currency sold
FXSI/FXIB).  Settlement instruction
 Confirmation sent to IM through
MT 304 Advice/Instruction of a Third
Party Deal

 This message is sent by a fund manager to a custodian bank as an

advice of/instruction to settle a third party foreign exchange deal.

 The fund manager arranges these deals either with an independent

(third party) Forex institution, the executing broker, or with the
treasury department of his custodian. Having exchanged and matched
the confirmation with the third party, the fund manager informs the
custodian about the deal. This is done for accounting as well as for
settlement purposes.

 The fund manager generates the MT 304 and sends it to

the global custody department of its custodian bank for settlement
(MT202+MT210) and accounting records.
Custodian Bank : Treasury department
What we are suppose to do ??

 The custodian bank enters the instruction into its accounting systems
for reporting and valuation.

 It is also entered into its payment system to effect payment depending

on the type of settlement. For a spot foreign exchange an MT 202 or
MT 210 may be generated; for a forward currency contract this may be
the settlement of a gain or loss via a separate currency payment.
Types of FX Contracts

Types of settlements

SPOT FORWARD SWAP

Greater than two Combination of

T+ 2 Working days Spot and Forward
Spot Contract:

Price of one currency quoted in terms of another currency for a

transaction to be effected within two working days T+2 (in some cases
within a 05 days).
e.g.
An Indian company purchases perfumes made in the United States
and immediately brings it in India to distribute to its employees. In this
case it’s a SPOT deal just like an individual making a purchase in a
shop and paying immediately. In such transaction, the Indian company
will have to pay the US manufacture in US dollars . To execute such
transaction ,this company will have to purchase dollar (ownership of
dollar deposit) in foreign exchange market by paying Indian Rupees.
Indian company will inquire in the foreign exchange market for the
price of dollar in terms of Indian rupee. Since the dollar-rupee quote
was asked for immediate transaction and dollars were purchased at
that rate , such transaction is referred as “Spot transaction”.
Spot foreign exchange
 indicates that the foreign exchange is a physical settlement in which both the buy and sell currencies will
move on the settlement (value) day.
 These transactions are generally executed to cover securities purchases, repatriation of sale proceeds into
the base currency of an account, and to cover a short cash position in another currency.
 Spot transactions may also be executed as an investment opportunity in currencies other than the base
currency of an account. They are also executed to close forward positions. There is no clear case in the
MT304 usage guidelines for netting a spot trade.

Sample message format


Forward contracts:

An agreement to exchange at a specified future date, currencies of

different countries at a specified contractual rate (forward rate) .
Foreign currency traded for settlement date Beyond two working days .
e.g.
A company in India places order for a boiler to be manufactured in
the United States. The boiler would be delivered after three months
from the date of order. At the time of delivery, the Indian company has
to pay USD10,000. In foreign exchange market, price of dollar in terms
of rupee changes every minute. Because of this , Indian company is
not sure how much would it cost after three months to purchase that
boiler, if Indian company wishes to fix the price at which it will
purchase dollars after three months , it has to enter into “ forward
contract”. It can get a quote from the foreign exchange dealer, for the
dollar price after three months .such rate would be different from the
Spot rate and is called as “forward rate”
Forward contact & Transaction
Risk

 e.g.
An Indian exporter exports goods with a bill value of $1000 on 1st
JAN when exchange rate is $1= 45 Rupee. US importer pays on
march 31st, after due credit period gets over. Exchange rate on 31st
march is $1=44 Rupees. then realized value of $1000 bill would be
Rupees 44,000( instead of Rupees 45,000). Here we can say , the
exporter faces transaction risk. They will be affected when price of
dollar goes up in terms of Indian rupees.
Transaction risk would be eliminated if the billing is in domestic
currency. In the above example if the bill value was Rupees 45,000
instead of “$ 1000” then exporter would have surety of getting the
correct value. However the American importer would be at risk
because for him he has to judge the dollar amount. This risk can be
hedge using forward contacts , futures, or options.
Activity daigram
Swap Contracts :

 Simultaneous purchase and sale of identical amounts of a currency

at different value dates. In most of the cases swap is a combination of
spot and forward in the opposite direction. In few cases it would be a
combination of two forward contracts of different value dates in
opposite direction, the purpose is to utilize the interest rate differential
in each country.
e.g.
One bank enters into an agreement with another bank to buy 1million
JPY for US dollars in spot market and also simultaneously agrees with
the same bank to sell 1 million JPY for US dollars after 60 days.
Exchange rate for both the transaction are agreed at the same time of
contract . This is a swap deal. Most of the forward contacts are
accompanied by an equivalent spot deal. Thus most of the forward
contracts are actually part of swap deal. Forward contracts without an
accompanying spot deal are called as “ outright forward contracts”.
NDF Deals : NON-Deliverable Forwards

 Non-deliverable forwards (NDF’s) operate very much like traditional

forward contracts with the exception that there is no physical delivery
of funds. Instead, the contract is cash-settled in USD at expiration.

 There are some currency regimes with limited exchange rate

and interest rate markets. This is evident in such emerging
market countries of southeast Asia, eastern Europe, and Latin
America where often local governments, to some degree,
restrict business access to off-shore entities.

 NDF act as hedging tools for such currencies.

CLS : Continuous Linked
Settlement

 Risk in Foreign exchange market : Settlement of foreign exchange trade require the
payment of one currency and the receipt of another. It is important that both the customer
honor their contract. It is possible that either of the parties will default. This is called as
Credit Risk. e.g collapse of bank of herstatt in 1974 (German)

 CLS is a global multi-currency settlement system that aims to eliminate foreign exchange
(FX) settlement risk due to time-zone differences. The CLS settlement service, provided by
CLS Bank, allows both legs of a FX trade submitted by members to be settled
simultaneously across the books of CLS Bank and therefore guarantees finality and
irrevocability of the settlements. It was launched in 2002.

 It avoids the high value payment risk, works on PVP mechanism ( payment vs. Payment ) .

 It is not for everyone : membership require the substantial amount of capital .

Forex risk & exposures

 Settlement Risk
 Transaction Risk
 Counterparty Risk
 Foreign Exchange Risk
 Credit Risk
Speculation and Hedging :

 Speculation : Deliberate creation of a position for the express purpose

of generating a profit from exchange rate fluctuations, accepting the
added risk.
 Speculators are of two kinds : Optimistic( Bulls) and Pessimistic
(Bears).

 Hedging : It refers to risk management strategy used in limiting or

offsetting probability of loss from fluctuation in the prices of
commodities, currencies, or securities.
Techniques use for Hedging

 Natural Hedging  Hedging by Contracts

It refers to operational changes and Instruments.
that mitigate or eliminate Forex Examples :

risk without use of contracts  Forward contract

Examples :  NDF
• Currency denomination or  Futures contract
• Invoicing  Options
• Netting and offsetting
• Leading and lagging
Thank you !!