Exchange Rate Mechanism

Types and Calculation

Due to vastness of the market operating in different time zones, most of the
forex deals are done on SPOT basis, meaning thereby that the delivery of
funds takes place on the second working day following the day of deal or
contract. The rate at which such deals are done is called the SPOT Rate.
Spot Rates are the basis for calculating other FX rates. The date of delivery
of the funds or the date on which the actual exchange of currencies takes
place is known as “value date”. The delivery of FX deals can be settled in
one or more of the following ways:
Ready or Cash
Settlement of funds on the same day (date of deal). For example, if the date
of Ready or cash deal is 25 -10-2004, settlement date will also be 25-10-
2004.
Tom
Settlement of funds takes place on the next working day of the date of deal,
e.g., if the date of deal is 25-10-2004, the date of settlement will be 26-10-
2004, provided it is a working day at the centre where the deal is made and
where settlement is to take place.
Spot
Settlement of funds takes place on the second working day following the
date of contract / deal,e.g, if the date of Spot deal is 25-10-2004, the
settlement date would be 27-10-2004, (presuming all markets are working
on 25, 26 and 27 Oct, 2004).
Forward
Delivery of funds takes place on any day after the spot date, e.g, if the date
of forward deal is 25-10-2004, for value 25-11-2004, it is a forward deal.
Spot and Forward Rates
As explained earlier, in the FX market, all rates quoted are generally “Spot
Rates”. The spot rates are for delivery of currency or exchange of the
streams of currencies dealt in, on the second day from the date of deal.
When the delivery of currencies is to take place on a date beyond the spot
date, then it is a forward transaction and the rate applied is called the
Forward rate.
Forward Margins – Premium and Discounts
Forward rates are derived from the spot rates, and are a function of spot rates
and forward premium or discount of the currency being quoted.
Forward Rate = Spot rate + premium or – discount.
If the forward value of a currency is higher than (costlier) the spot (present)
value, then the currency is said to be at a premium and if the forward value
of a currency is lower than (cheaper) the spot rate, then the currency is said
to be at a discount. For example, if the GBP / USD spot rate is quoted as
1.8350 and one month forward is quoted as 1.8450, then GBP is dearer
against dollar one month forward and hence there is a premium of 100 pips.
On the other hand, if the one month forward rate is 1.8300, then GBP is at a
discount against USD and one month forward discount id 50 pips.
Similarly, if INR spot is being quoted against USD as 45.50 / 52, then it
means that USD is being bought for 45.50 and sold for 45.52. Now if six
month forward premium is quoted as 40/42 paisa, then, USD is being quoted
dearer in the forward market and is being quoted as 45.90 / 94. In this case,
USD is at a premium and INR is at a discount.
The forward premium and discount are based on the interest rate
differentials of the two currencies involved, as also the demand and supply
of the forwards in the market. The demand and supply depend upon various
factors such as movement of capital in the normal course, flight of capital,
trade and balance of payment position and their financing, labor problems,
political activities, speculative activities etc.
Direct & Indirect quotations
In Direct Quotations, the home currency is variable against foreign
currency such as 1 USD = RS.46.50. In the Indirect quotations, the Foreign
Currency is variable such as RS.100 = USD 2.1250. Globally, it is now a
practice to use Direct Quotations (except in few currencies). Only in case of
GBP, AUD, NZD and EUR, indirect quotations are used, i.e., ONE GBP,
AUD, NZD or EUR equal to so many USD.
Cross Rates
When n we deal in a market where rates for a pair of currencies are not
directly available, the price for the said currency pair is then obtained
indirectly with the help of cross rate mechanism.
Suppose we want a quote for INR / EUR, and no one is prepared to quote
directly in the market. We can calculate the EUR / INR rate from EUR /
USD rate and USD / INR rate. The former would be available in the
international markets and the latter in local market. This is how cross rates
are worked out. If USD / INR is 45.50/60 and GBP / USD is 1.8340/50.
Then GBP / INR rate would be 83.2636 /83.4925.
Fixed and Floating Rates
The fixed exchange rate is the official rate set by the monetary authorities
for one or more currencies. It is usually pegged to one or more currencies.
While, under floating exchange rate system, the value of the currency is
decided by demand and supply forces. In some cases, even fixed exchange
rates are allowed to fluctuate in a narrow band as fixed by the monetary
authorities of the country.
Bid and Offered Rates
The buying rates and the selling rates are also referred to as Bid and Offered
rates. IN a USD / INR quote of 45.00/02, the bank is bidding for USD at
45.00 and is offering to sell at 45.02. On the other hand, in a GBP / USD
rate of 1.8810 / 15, the quoting bank is willing to buy GPB at 1.8810 and
sell at 1.8815.
Exchange Arithmetic
All foreign exchange calculations are to be worked out with great care and
accuracy, since the markets work on very thin margins. A small error in one
quote may wipe out the gains of many trades and transactions.
Arbitrage in Exchange
Arbitrage consists of simultaneous buying and selling of a commodity in
two or more markets to take advantage of temporary discrepancies in prices.
In respect of FX, arbitrage consists of purchase of one currency at one
centre, accompanied by an almost immediate sale of the same currency in
another market or in operations conducted in three or more centers involving
several currencies. A transaction conducted in a single currency in two
centers is known as a simple or direct arbitrage while an arbitrage involving
more than two centers and involving two or more currencies is known as a
multipoint and multi currency arbitrage. Such operations must be conducted
very swiftly if advantage of price differentials is to be taken as prices get
adjusted very fast.
Rates quoted to merchants or retail transactions are specified by the
nature of transactions. By this, different rates could be applied for TT, Bills
transactions, foreign money or cash transactions, Travelers’ checks etc. The
rates would be different for buying and selling transactions, levying different
margins over the inter bank rate, depending upon the nature of the
transaction.
Foreign Exchange Dealing Room Operations
The FX dealing room operations comprise functions of a service branch to
meet the requirements of customers of other branches / divisions to buy or
sell foreign currency, fund nostro accounts as also undertake proprietary
trading in currencies. It acts as a separate profit center for the bank.
The dealers who actually handle the buying and selling of currencies are
the critical manpower, as their understanding of the job, risk taking capacity
and speed in decision making all lead to high profits for the dealing room.
On the other hand, a small mistake, a misjudgment may wipe off all day’s
profit in a few seconds. Good dealers need to have certain qualities like
ability to work under stress, willingness to accept challenges, the ability to
grasp market changes quickly and take appropriate decisions,
aggressiveness, and above all to recognize that one can go wrong. There
must exist an atmosphere of complete trust within the dealing room.
A dealer has to maintain two positions – Funds position and currency
position. The funds position reflects the inflow and outflow of funds, or
receivables and payables. Any mismatch in receivables and payables will
throw open interest rate risks, in the form of a possible overdraft interest in
the nostro accounts or loss of interest on credit balances. It is very important
for a dealer to maintain accurately the funds position in various currencies.
The currency positions, on the other hand, deals with the overbought or
oversold positions in various currencies on account of merchant or inter
bank transactions which exposes the dealer to exchange risk from market
movements. The dealer has to operate within the permissible limits for
currency position prescribed by the management for various currencies.
The other part of the dealing room is the Back Office, which takes care of
processing of deals, accounting, settlements and reconciliation etc.This
function is also equally important and any laxity in this regard also could
lead the institution into difficulties. Either it may negate the efforts of the
dealers to maximize profits or it could be so lax as to permit dealers indulge
in misreporting and wrong doings, without the notice of the back office. The
back office thus has both a supportive as well as a controlling role over the
dealing room.
The third part is the Mid Office which deals with the risk management
and parameterization of risks for FX dealing operations. It acts as a check
over the risks taken by the dealers and also supplements them with market
information.
With the increasing volume of FX transactions owing to the growing
international trade, both in goods and services, cross border flow of money
and also the authorized dealers undertaking currency trading, the need for
exercising management control over dealing room activities to evaluate
profit / loss generation and adherence to prescribed procedures has assumed
great importance.
RBI has approved Foreign Exchange Dealers’ Association of India
(FEDAI), guidelines on Uniform Standard Accounting Procedure for
valuation of foreign exchange profits and losses by authorized dealers,
which should be undertaken at least on quarterly basis. However, automation
of dealing room operations has enabled evaluation of dealing room
operations more frequently, or even on daily basis.
Management and Control of a Dealing Room
RBI has advised that the Boards of Directors of Banks should frame an
appropriate policy and fix suitable limits for its FX dealing operations. The
management of dealing room operations should focus on risk arising out of
volatility and complexity in the exchange markets. The major risks
associated with FX dealing operations where the management needs to
frame policies and keep a constant vigil are –
i) Operational Risks,
ii) Credit Risks,
iii) Exchange Risks,
iv) Settlement Risks,
v) Liquidity Risk,
vi) Gap or Interest Rate risk,
vii) Legal risk,
viii) Country Risk,
ix) Systemic Risk, and
x) Sovereign Risk.
A comprehensively effective management of dealing room operations would
involve identification, measurement and mitigation of these risks.
FX dealing is a highly specialized function and has to be preformed by
well trained personnel. The dealing staff and the back office staff should be
sufficiently segregated so that the control on dealing staff is not diluted.
RBI / FEDAI Guidelines
The Reserve bank of India, being the central bank of the country and the
custodian of the FX reserves of the county has prescribed guidelines for
authorized dealers licensed by it to deal in foreign exchange and handle
transactions in foreign currencies. FEMA 1999 also prescribes the statutory
rules in this regard. At present, there are about 100 authorized dealers in FX
in India.
 Foreign Exchange Dealers’ Association of India is a non profit
organization formed in 1958 with the approval of RBI consisting of
authorized dealers as members. FEDAI prescribes ground rules of the game
for market operations, merchant rates, quotations, delivery dates, holidays,
interest on default etc .In terms of RBI guidelines, all authorized dealers are
members of FEDAI and it is mandatory on them to follow FEDAI
guidelines. FEDAI guidelines also prescribe rules relating to handling of
export / import bills, transit period, crystallization of liabilities and other
related issues. It also advises RBI on market related issues and supplements
the efforts of RBI to strengthen the FX market in the country. Major FEDAI
guidelines can be summarized as under –
1) All export bills to be allowed standard transit period, as prescribed,
for the purpose of allowing concessional interest rates and calculation
of notional due dates.,
2) Export bills drawn in foreign currency, purchased /discounted/
negotiated by banks must be crystallized into rupee liability on the
30th day from the notional due date, incase of non realization of export
bills by that date. The same would be done at TT selling rates.
3) Bills drawn under import letters of credit would be crystallized on the
1oth day after the date of receipt if not paid by the opener.
4) All forward contracts must be for definite amounts and for specific
delivery dates.
5) In case of option contracts, option period can be specified by the
customer but, in any case, the delivery period under the option
contract shall not exceed beyond one month, All such contracts must
state the start and the end date.
6) All contracts, which have matured and have not been picked up, shall
be automatically cancelled after the 15th day from the date of maturity.
7) All cancellations shall be at the opposite TT rates of the bank.
8) In the case of delay in the payment of inter bank foreign currency
funds, interest at 2% above the bank’s prime rate for the currency
shall be charged.
9) In the event of delay in settlement of rupee funds, interest at 2% above
MIBOR / NSE rate shall be charged.
10) All currencies to be quoted as – per unit of foreign currency
=INR, while JPY and ITL to be quoted as 100 units of JPY or ITL
=INR.
11) FEDAI also prescribes code of conduct for FOREX dealers, as
also guidelines with regard to dealings with FOREX brokers.