Exchange Rates and Forex Business

Module A: International Banking

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Bank Financial Management: Exchange Rates and Forex Business

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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
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1.

FOREIGN EXCHANGE DEFINITION AND MARKETS

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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.

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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.

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ForEx Market Participants

Central Banks
Commercial Banks
Investment funds/banks
ForEx brokers
Corporations
Individuals

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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

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2.

FACTORS DETERMINING EXCHANGE RATES

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Factors Determining Exchange Rates

Fundamental
Reasons

Technical
Reasons

Speculation

Balance of Payment
Economic Growth Rate

Freedom or Restriction
of Capital Movement
due to Govt. Controls

Fiscal Policy

Provides depth and

liquidity to the market
and acts as a cushion

Monetary Policy
Interest Rates

Movement to high
yielding currencies

Political Issues

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3.

EXCHANGE RATE MECHANISM

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Types of Transactions
Ready/Cash

Settlement of funds on the same day (t+0)

Tom

Settlement of funds on the next working day (t+1)

Spot

Settlement of funds on the second working day

(t+2)

Forward

Delivery of funds on any day after the spot date

Value date

Date on which exchange of currencies actually takes place

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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
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Type of Quotes
Direct Quote

Indirect Quote
Two-way 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

Home currency expressed in terms of foreign

currency
Ex: Rs. 100 = USD 2.25.

Inter bank quotes

Internationally, all currencies other than GBP, Euro, AUD and NZD are quoted as direct rates.
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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

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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.

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Bid and Offered Rates

Bid rate: Buying Rate
Offered Rate: Selling Rate

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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

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4.

FOREIGN EXCHANGE DEALING ROOM OPERATIONS

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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.

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Dealers who are

actually involved in
buying and selling the
currencies, or
undertaking market
activities.

Risk Management,
and parametrization
of Risks for forex
dealing operations.
Compliance of
guidelines and
instructions.

Back Office

Dealing Room

Mid Office

Front Office

3 Parts of a Dealing Room

Follow up and
Processing/Settlement
of deals, Accounts,
Reconciliation etc.

MIS

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Positions
Funds Position
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
Currency Position
Deals with overbought or oversold positions.
The overall net position exposes the dealer to exchange Risks
from market movements.
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Terminology
Exchange
Position/Position

Overbought Position

Oversold 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.

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

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

Open Position

O/N 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

Exchange position at given

point of time

Open Exchange position at

the end of the day

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Major Risks associated with ForEx Dealing Operations

Exchange Risk

Credit Risk

Presettlement
Risk

Settlement
Risk

Liquidity Risk

Gap
Risk/interest
rate Risk

Market Risk

Legal Risk

Systemic Risk

Country Risk

Sovereign Risk

Operational
Risk

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5.

RBI/FEDAI GUIDELINES

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Categorisation of Authorised Persons

Cat 1

Cat 2

Cat 3

Authorised Dealer
Banks
Financial
Institutions
Other entities
permitted to
handle all types of
ForEx transactions
Earlier known as
Authorised Dealers

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)

Allowed to
undertake only
purchase of FC
notes and
travellers cheques
Earlier known as
Restricted Money
Changers (RMCs)

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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 Banks opposite TT rates

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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.
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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

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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

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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

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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

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

Just mark an email to super.msahluwalia@yahoo.com

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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

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