Management of Forex Transactions

Recommended Books:
 International Financial Management

by Jeff Madura
 International Financial Management

By P.G.Apte
 Foreign Exchange : Practice,
Concepts and Control by C.
Jeevanandam
Foreign Exchange
Introduction

Prof Mahesh Kumar

Amity Business School
profmaheshkumar@rediffmail.com
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
Introduction
 Every nation has its own currency. Most
international financial transactions involves an
exchange of one currency for another.
 The price of one currency in terms of another is
known a exchange rate.
 Foreign exchange markets provide the
mechanism of exchanging different monetary
units.
 Foreign Exchange Markets facilitate transfer of
purchasing power from one country to another.
Introduction
 Apart from trade, sometimes, nationals of one
country may prefer to hold financial assets in a
foreign currency or denominate in foreign
currency because domestic currency is subject
to high inflation and therefore less attractive as
a store of value.
 Exchange dealers do the job of exchange of
currencies.
 The demand and supply in the foreign
exchange market permits the establishment of
rates of different currencies in terms of local
currencies.
Importance of Foreign Exchange Markets
 Foreign exchange markets role is of paramount
importance in the system of international
payments.
 Reliability, essentially concerned with
contractual obligations being honoured, is one
of the important feature of foreign exchange
market.
 BASIC CONCEPTS/TERMINOLOGIES
Foreign Currency vs. Foreign Exchange

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;
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.
Forex Transactions

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.
 Repatriation of profit of foreign controlled
companies and ‘freight collection’ etc.
 A host of other invisible payments.
 Disinvestment through SCRA
Forex Transactions

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.

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

 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
Exchange Rate

Is the price of foreign currency.

INR/USD is usually stated as Indian
rupees per dollar. An increase in
exchange rate implies depreciation in
currency and vice versa.
Foreign Exchange –Market Types
 Markets driven by float method- Central bank
does not buy or sell foreign exchange and the price is
determined in private market place. Exchange rate is
determined by demand and supply of foreign
exchange.
 Markets driven by fix method- Central bank fix
their exchange rates by active trading in the fx
market.
 Markets driven by intermediate method- Central
Bank practices managed floating whereby they
intervene in the FX market by leaning against the
wind. Central Bank sells foreign exchange when the
exchange rate is going up thereby dampening its rise
and buying when it is going down so as reduce the
variability in the exchange rate.
Forex Market-Control & Influencing Factors

 Market Sterilization :An increase in foreign

exchange reserves will add to the money supply
which could lead to inflation. To offset central bank
takes steps which are known as sterilization
operations. A common way to accomplish it is by
selling bonds in the open market or by increasing
the reserve requirements for commercial banks.
Factors affecting foreign exchange rates
 Fundamental factors: Exports and imports of
merchandise.
 Political and psychological factors
 Technical factors
- capital movement
- relative inflation rates
- exchange rates policy and intervention
- Interest rates
 Speculation
 Others: Macro economic fundamentals like growth
rate of economy, trade balances, inflation rates
etc.
Types of Foreign Exchange Markets
The major foreign exchange markets that exist
are:
1. Spot markets
2. Forward markets
3. Futures markets
4. Options markets
5. Swaps markets

 Futures, Options & Swaps are called

derivatives because they derive their value
from underlying exchange rates.
Types of Foreign Exchange Markets
 Spot market refers to the transactions
involving sale and purchase of currencies for
immediate delivery. In practice, it may take
one or two days to settle the transaction.
 Forward market transactions are meant to be
settled on a future date as specified in the
contract. Though forward rates are quoted just
like spot rates, but actual delivery of currency
takes place much later, on a date in future.
 Future market transactions are meant to be
settled on exchange on a future date as
specified in the contract.
Types of Foreign Exchange Markets
 Options are derivative instruments that give a
choice to foreign exchange instruments that
give a choice to foreign exchange operator to
buy or sell a foreign currency on or up to a
date (maturity date) at a specified rate (strike
price).
 Swaps, as the very term suggests, are simply
the instruments that permit exchange of two
streams of cash flows in two different
currencies.
Important Foreign Exchange Markets
 The most active foreign exchange market is
that of UK (London) followed by that of USA,
Japan, Singapore, Switzerland, Hong Kong,
Germany, France & Australia.
 All other markets, combined together,
represent only about 15% of the total volume,
traded globally.
Volume of Transactions
 International trade represents only a small
part of foreign exchange operations.
 Movement of capital & currency positions held
by banks constitute a major segment of
exchange business.
 About 5% of volume traded on markets
represents the need of international trade and
international tourism. 10-15% pertains to
movement of capital like investment funds.
Volume of Transactions
 The larger part of currency movements are of short
term type and the bulk comes from foreign
exchange operations of big commercial banks.
 This percentage may however undergo changes in
futures. Firstly because foreign exchange needs
due to trade are developing at a faster pace than
those due to inter bank exchanges. Secondly, after
coming into existence of common currency, like
Euro, profit due to exchange operations by
different banks within European Union are going to
disappear.
Characteristics of Foreign Exchange Market
 The transactions on exchange markets are
carried out among banks. Rates are quoted
round the clock. Every few seconds quotations
are updated.
 Quotations start in the dealing room of
Australia & Japan (Tokyo) and they pass on to
the markets of Hong Kong, Singapore, Bahrain,
Frankfurt, Zurich, Paris, London, New York,
San Francisco & Los Angeles before restarting.
Characteristics of Foreign Exchange Market
In terms of convertibility there are three kind of currencies:
1. The first kind is fully convertible in that it can be freely
converted into other currencies.
2. The second is partly convertible for non residents.
3. The third kind is not convertible at all and it holds true for
currencies of a large number of developing countries.
 It is the convertible currencies which are mainly quoted on the
foreign exchange markets. The most traded currencies are US
dollars, Deutsche Mark, Japanese Yen, Pound Sterling, Swiss
Franc, French Franc & Canadian Dollar.
 Currencies of developing countries such as India are not yet
in much demand internationally. The rates of such currencies
are quoted but their traded volumes are insignificant.
Characteristics of Foreign Exchange Market
 The composition of transaction in terms of
different instruments varies with time. Spot
transactions remain to be the most important
in terms of volume. Next come Swaps,
Forwards, Options & Futures in that order.
Typical Distribution of Counterparties of
Banks in the Foreign Exchange Market

Counterparty Percentage

Exchange Brokers 42.5

Non Resident Banks 25.2

Resident Banks 17.3

Other Clients 15.0

Dealing Room
 All the professionals who deal in currencies, options,
futures and swaps assemble in dealing room. This is
the forum where all transactions related to foreign
exchange in a bank are carried out.
 There are several reasons for concentrating the
entire information and communication system in a
single room. It is necessary for the dealers to have
instant access to the rates quoted at different places
and to be able to communicate amongst
themselves, as well as to know the limits of each
counterparty etc. This enables them to make
arbitrage gains, whenever possible.
Connection with Commercial Banks
 Commercial banks which participate in the
market communicate between themselves
through a network of telephones, faxes and
the means of communication supplied by
Reuters, Telerate, Bloomberg etc.
 Similarly economic, political and financial news
which is likely to influence the markets is
communicated rapidly.
Competing Automatic Trading System
 There are number of trading systems e.g.
1. Reuters- ‘Dealing 2000’ which ensures automatic
execution of orders. This means that dealer who places
an order is automatically linked to a counter party
instead of his having to search for counterparty.
2. Other system is known as ‘Electronic Booking System’
(EBS) which provides trading platform to a group of 200
dealers in 60 banks and institutions.
3. Another system is MINEX which is supported by a
consortium of Japanese banks, Japanese Brokers,
Japanese company of telecommunication, KDD &
Telerate and is used particularly in the Asian region.
Competing Automatic Trading System
 The advantage of the above systems is that it
enables the operators to
1. Reduce commission charged by brokers.
2. Know rapidly the divergences which may
appear, for instance, with respect to interest
rates on the one hand and spot and forward
rates on the other. Significant difference may
yield arbitrage operations profitable for them
The Front Office and Back Office
 The dealers who work directly in the market and are
located in the dealing rooms of big bank constitute
the Front Office.
 They meet the clients regularly and advise them
regarding the strategy to be adopted with regard to
their treasury management.
 The role of dealer is two fold
1. To manage the positions of client.
2. To quote bid-ask rates without knowing whether a
client is a buyer or a seller. Dealer should be ready
to buy or sell as per the wishes of the client and
make profit for the bank.
The Front Office and Back Office
 The dealers also need to consider the limits fixed by the
Management of the bank with respect to each single
operation or single counterparty or position in a
particular currency. Dealers are judged on the basis of
their profitability.
 The operations of front office are divided into several
units. There can be sections for money market and
interest rate operations, for spot transaction, for
forward market transactions, for currency options, for
dealing in futures & so on.
 Each transaction involves determination of amount
exchanged, fixation of an exchange rate, indication of
date of settlement and instructions regarding delivery.
The Front Office and Back Office
 The Back Office (BO) consists of group of persons who
work, so to say, behind the FO. Their activities include
managing of the information system, accounting,
control, administration and follow up of operations of
Front Office.
 Back Office ensures an effective financial and
management control of market operations.
 In principle, Front Office and Back Office should function
in a symbiotic manner on equal footing.
Forex Market- Definition & Introduction
 Def: The foreign exchange is the market in which
foreign currency e.g. USD, GBP, JPY,EURO is traded for
domestic currency e.g. INR.
 Forex Market is a decentralized network highly
integrated via modern information & telecommunication
technology.
Spot Market
Futures Market
Forex Market Options Market
Forward Market
Swap Market
Salient Features of Forex Market
Location
 Foreign exchange market is an OTC market as there is no
place where participants meet to execute the deals.
 The term foreign exchange market is used to refer to the
wholesale segment of the market, where the dealings take
place among the banks.
 The retail segment refers to the dealings that take place
between banks and their customers.
 The leading foreign exchange market in India is Mumbai.
Kolkata, Chennai and Delhi are the other major centres.
Salient Features of Forex Market
Size of the Market
 Foreign exchange market is the largest financial market in
the world.
 The average daily turnover is USD 3.98 trillion.
 The largest foreign exchange market is in London followed
by New York, Tokyo, Zurich and Frankfurt.
 Indian Rupee (INR) is not an internationally traded
currency as it is involved in only 0.3% of the transactions
taking place in world foreign exchange markets.
 USD, GBP, Euro, JPY and Swiss Franc are the leading
currencies in which most of the global trade takes place.
Salient Features of Forex Market
24 hour Market
 Foreign exchange market functions throughout

24 hours of the day.

 In India, the market is open for the time the

banks are open for their regular banking

business. No transactions take place on
Saturdays and Sundays.
Salient Features of Forex Market
Efficiency
 Developments in communications have largely

contributed to the efficiency of the market and

the foreign exchange markets are very efficient
financial markets.
 Any significant development in any market is

almost instantaneously received by other

market situated at a far off place and thus has a
global impact.
Salient Features of Forex Market
Currencies Traded:
 US dollar is the vehicle currency used to
denominate international transactions.
 US dollar is involved in approximately 87% of

foreign exchange transactions followed by Euro

(37%), Japanese Yen (20%) and Pound Sterling
(17%).
 Most traded pairs of currencies are USD/Euro

(28%), USD/JPY (20%) and USD/GBP (17%).

 Exchange rate between USD/GBP is also known as

CABLE
Participants of Forex Market
 The participants of foreign exchange market comprise:
1. Corporates: They operate in the market to meet their
genuine trade or investment requirements.
2. Commercial banks: They buy and sell currencies for their
clients. They also operate on their own. When the bank
enters a market to correct excess sale or purchase
position in a foreign currency arising from its various
deals with its customers, it is said to a cover operation.
However major volume of foreign exchange trade by the
bank is to gain from exchange movements.
3. Exchange brokers: They ensure that the most favorable
quotation is obtained at a low cost in terms of time and
money.
4. Central Banks:
Purpose of Transacting
There are three main purposes for transacting in
forex market:
1. Hedging: Hedgers are those who have an
exposure to risk and resort to foreign exchange
market as a means of covering their position.
Hedging is the method of entering into an
opposite position in the market to that of the
position held in a currency so that ultimately the
position becomes zero.
Purpose of Transacting
2. Speculation: Speculators enter into deals with
the expectation of making profit out of such
transactions. A speculator watches the market
carefully and makes his own estimates of the
future movements in the rates. Based on his
estimates he makes moves in the market and
hopes to gain from the ultimate results.
Speculators as a class are risk takers. They are
the cause for both volatility and efficiency of the
market.
Purpose of Transacting
3. Arbitrage: Arbitrageurs keep constant vigil on
the market, across products and locations, to
identify temporary imperfections and convert
such opportunities into risk less profits. In pure
form of arbitrating, the operator:
a) Has no investment and
b) Simultaneous buys and sells in different markets
and/or for different periods which ensures risk
less profits to him.
Settlement of Transactions
 Banks use exclusive network SWIFT (Society for
Worldwide Interbank Financial Telecommunication) to
communicate messages and settle the transactions at
electronic clearing houses such as CHIPS (Clearing House
Interbank Payment System) at New York and CHAPS
(Clearing House Automated Payment System) at London.
 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
Vostro accounts at Reserve Bank of India (RBI).
Transactions in Interbank Markets
 In foreign exchange transactions two points need to be kept in mind:
a) The transaction is always talked of from the quoting bank’s point of
view;
b) The item referred to is the foreign currency
 Therefore when we say purchase, we imply that
a) The quoting bank has purchased
b) It has purchased foreign currency
 Similarly when we say a sale, we imply that
a) The quoting bank has sold; and
b) It has sold foreign currency.
 Thus in purchase transaction the quoting bank acquires foreign
currency and parts with home currency. In a sale transaction the
quoting bank parts with foreign currency and acquires home currency.
Types of Transactions
 The transactions in inter-bank market may fall under
any of the following categories:
a) Spot transactions
b) Forward transactions
c) Swap transactions
d) Non-deliverable forwards
Types of Transactions
a) Spot transactions:
 These are transactions where the exchange of currencies
take place two days after the date of contract.
 The date on which the currencies are exchanged is the
value date.
 Both the currencies are paid on the same day so that there
is no loss of interest to either of the parties.
 Where the agreement to buy or sell is agreed upon and
executed on the same date, the transaction is known as
cash or ready transaction. It is also known as value today.
 A transactions in which the currencies are to be exchanged
on the next day the transaction are known as value
tomorrow or tom transaction.
Types of Transactions
b) Forward Transactions:
 The transaction in which the exchange of currencies takes
place at a specified future date, subsequent to the spot
date, is known as a forward transaction or outright forward
transaction.
 The forward transaction can be for delivery one month or
two months or three months etc.
 A forward contract for delivery one month means the
exchange of currencies will take place after one month
from the date of contract.
 The date of forward contract will be calculated from spot
date. For instance, 1 month forward contract entered into
on 22nd March will fall due on 24th April.
Types of Transactions
c) Swap Transaction:
 A swap transaction is a deal between the same
counterparties in which the same currency for same value
is purchased and sold for different maturities.
 For instance, Dena Bank and IDBI Bank agree under
which Dena Bank buys USD 5 million spot and sells it
forward for 2 months.
 The difference between the spot price and forward price is
equivalent to the forward margin and is also known as
swap point.
Types of Transactions
d) Non Deliverable Forwards
 In this type of transaction, on the due date, the spot rate
for the currency concerned is compared with the forward
rate agreed under the contract and the difference is
settled.
 The settlement is invariably done in US dollars.
Quotations in Inter Bank Markets
 The big banks in the market are known as market
makers, as they are willing to buy or sell foreign
currencies at them up to any extent.
a) Two Way Quotation:
 Typically, the quotation in the inter bank market is a two
way quotation. It means, the rate quoted by the market
maker will indicate two prices, one at which it is willing to
buy the foreign currency, and the other at which it is
willing to sell the foreign currency. E.g. USD
1=Rs.46.1523/1650
 The buying rate is also known as the bid rate and the
selling rate as the ask rate. The difference between these
rates is the gross profit for the bank and is known as the
spread.
Quotations in Inter Bank Markets
a) Direct Quotation:
 The exchange rate quotation which gives the price for the
foreign currency in terms of the domestic currency is known
as direct quotation.
 In a direct quotation, the unit of foreign currency is kept
constant and change in price is indicated by the change in
the number of units of the domestic currency equivalent to
one foreign currency.
 Direct quotation is also known as home currency quotation.
 The Maxim- Buy Low; Sell High: The prime motive of any
trader is to make profit. In foreign exchange too, the bank
buys the foreign exchange at a lesser price and sells it at a
higher price. For instance it may buy US dollars at Rs.48 and
sell at Rs.48.10. Thus in direct quotation the principle
adopted is buy at a lower price and sell at higher price.
Quotations in Inter Bank Markets
b) Indirect Quotation:
 The type of quotation that gives the quantity of foreign
currency per unit of domestic currency is known as
indirect quotation.
 In indirect quotation, the unit of domestic currency is
kept constant and the change in the price of the
currency is indicated by the varying units of the
foreign currency for fixed sum of domestic currency.
 Indirect quotation is also known as foreign currency
quotation or simply currency quotation.
 The Maxim-Buy High; Sell Low: For example, for
Rs.100, the bank may quote a selling rate of USD 2.30
and buying rate of USD 2.31. The difference between
USD 2.31 and USD 2.30 is the bank’s margin of profit.
Quotations in Inter Bank Markets
c) American and European Quotation:
 Interpretation of quotations as direct and indirect is not
convenient when the market quotes rates for two
currencies neither of which is the domestic currency.
 International markets adopt the US dollar as the standard
currency and exchange rates are quoted in terms of or
against this currency.
 The quotation is in American terms when the rate is
expressed as so many units of US dollars per unit of
foreign currency.
 The quotation is in European terms when the quotation is
the number of foreign currency per unit of US dollar.
 In international markets rates are generally quoted in
European terms.
Quotations in Inter Bank Markets
d) Cross Rates and Chain Rule:
 The exchange rate in the foreign exchange market
is quoted in terms of the standard currency, viz US
dollar. The exchange rate between a pair of
currencies, neither of them being US dollar is
worked by using the rate for each of these
currencies in terms of US dollars.
 For instance, suppose the rate of Swiss Franc is
required in terms of Indian rupees and the rates of
Mumbai market are as under
USD 1 =Rs.46.50
USD 1 = CHF 1.8000
 The rate of Swiss Franc in terms of rupees can be
calculated by ’chain rule’ as follows:
Quotations in Inter Bank Markets
?Rs. = CHF 1
if CHF 1.80= USD 1
USD 1 = Rs.46.50
 It should be noted that the currency which appears
as the second item (the right hand side) in the first
equation appears as the first item (left hand side) in
the second equation. US dollars which appears on
the right hand side in the second equation appears
on the left hand side in the third equation.
 The rate of exchange between Indian rupee and
Swiss franc can be calculated by dividing the product
of the right hand side by the product of the left hand
side.
46.50*1*1/1.80= Rs.25.83
Quotations in Inter Bank Markets
d) Forward Rates
 Forward rate may be the same as the spot rate
for the currency.
 More often the forward rate for a currency may
be costlier or cheaper than its spot rate.
 The difference between the forward rate and the
spot rate is known as the ‘forward margin’ or
‘swap points’.
 The forward margin may be either at ‘premium’
or at ‘discount’.
Quotations in Inter Bank Markets
 If the forward rate is at premium, the foreign
currency will be costlier under the forward rate
than under the spot rate.
 If the forward margin is at discount, the foreign
currency will be cheaper for forward delivery
than for spot delivery.
 Under direct quotation, premium is added to the
spot rate to arrive at the forward rate. This is
done for both purchase and sale transactions.
 Discount is deducted from the spot rate to arrive
at the forward rate.
Interpretation of Inter Bank Quotations
 The market quotation for a currency consists of the spot
rate and the forward margin.
 For instance, US dollar is quoted as under in the inter bank
market on 25th January as under:
Spot USD 1= Rs.48.4000/4200
Spot/ February 2000/2100
Spot/ March 4000/3600
 From above quotations following points are to be noted:
1. The quoting bank’s spot buying rate is 48.4000 and the
selling rate is Rs.48.4200
2. Spot/ February rate is valid for delivery end February.
Spot/ March rate is valid for delivery end March.
3. The margin is expressed in points, i.e.0.0001 of the
currency. Therefore the forward margin for February is 20
paisa and 21 paisa
Interpretation of Inter Bank Quotations
4. The first rate in the spot quotation is for buying and
second for selling the foreign currency. Similarly it is
in the case of forward rates. Taking Spot/February as
an example, the margin of 20 paisa is for purchase
and 21 paisa for sale of foreign currency.
5. When the forward margin is in ascending order as in
case of Spot/ February it indicates that the forward
currency is at premium. The outright forward rates
are arrived at by adding the forward margin to the
spot rates.
6. Similarly if the forward margin is in descending order
as in case of Spot/ March it indicates that the
forward currency is at discount. The outright forward
rates are arrived at by deducting the forward margin
to the spot rates.