Foreign Exchange, Treasury and Market Risk Mangement-1

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Introduction
Foreign Exchange, Treasury and Market Risk Management is a three credit module. Basics of
Foreign exchange, exchange rates, regulations and other important aspects are introduced to
the learner through the ten units that the module comprises of Foreign exchange transactions,
risks associated with foreign exchange and the management of such risks are discussed in
detail in this module. The aforesaid knowledge and skills are very important for modern
generation bankers. This module aims to initiate learners into the basics of Foreign Exchange,
Treasury and Market Risk Management. The module has been designed keeping in mind
learner requirement and from learner‟s perspective.
This reading material is part of the courseware provided by Nitte Education International
Private Limited (hereinafter referred to as “NEIPL”), to students of PGD(B&F) course. The
proprietary rights to the material rests with “NEIPL”. No part of the reading material may be
reproduced, photocopied or transmitted in any form without prior written permission of
“NEIPL”.
All efforts have been made to ensure correctness of information in the reading material and to
provide the latest information. However, there are bound to be changes in the industry and
NEIPL reserves the right to change and update information from time to time. NEIPL is not
liable for any loss or damage arising from the use of the information provided.
Reference: NEI/PGD(B&F)/2018/FETMRM/CNSB3.4V1
Post Graduate Diploma (Banking & Finance)

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Unit 1
This unit deals with:
 Introduction to Treasury.
 Treasury & its role in Banks.
 Responsibilities of treasury including ALM.
 Structure of Treasury, Front, Back and Mid Office.
 SGL and Constituent SGL Accounts.
 Introduction to Investment Portfolio of a Domestic Treasury.
 Role of FIMMDA (Fixed Income Money Market and Derivatives Association).
Introduction
Treasury means managing treasure or valuables. The valuables here belong to the
Government of India, which are in the form of in-flows and out-flows of cash, credit,
foreign exchange and other financial instruments.
Till 1990s the role of the Treasury in Indian Banks was limited to ensuring the maintenance
of the Reserve Bank of India [RBI] stipulated forms of Cash Reserve Ratio [CRR] and
Statutory Liquidity Ratio [SLR]. Even activity in foreign exchange market was restricted to
meeting the merchants and customer requirements for import, export, remittances and NRI
deposits.
The RBI has since initiated various measures to reform the money market. To further widen
as also deepen the Indian money market, RBI has put in place the required institutional
infrastructure in the form of an Institution in the name of Discount and Finance House of
India Ltd., [DFHL].DFHL was initially set up, to meet liquidity requirements by dealing in
short term money market instruments like, treasury bills, bills rediscounting facility.
Subsequently, short term money market instruments in the name of commercial paper [CPs]
and commercial deposit [CDs] were introduced, which boosted the development of money
market in India.
To give a further boost to the development of money market, non-banking institutions viz.,
Mutual Funds, LIC of India, FIs were permitted to enter the call money market initially only
as lenders. Later the Government of India made amendments into the Delivery versus
Payment system of securities settlement in the Public Debt Office [PDO] at RBI. This
change resulted in not only reduction in counter party risk in transfer of securities from one
party to the other but also development of an altogether new money market instrument
popularly known as “Repos”. Today Repo is an important money market instrument.
Activity in foreign exchange was confined to meeting merchants` and customers`

requirements for imports, exports, remittances and deposits. Furthermore, Indian Money
Market was characterised by the imperfections arising from administered interest rates. Due
to liberalisation and globalisation the financial markets in India were deregulated to a large

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extent. This led to market determined foreign exchange rates and the freeing of most bank
deposits and lending rates. With freeing of foreign currency exchange rate, the forward
market became active and also became a source of profit. The foreign exchange rates
became volatile which led to huge fluctuation in both intra-day and inter-day prices, thereby
enabling traders to book profits on buying and selling of foreign currencies.
Cross-currency trading which was in its infancy, became a tall boy among Indian Banks.
Dealers took positions in domestic market as also foreign markets. In fact the Indian banks
which were known as a mere CRR/SLR keeper matured in the financial markets and
transformed themselves to Treasuries as a profit centre. The movement in interest rates,
volatility in foreign exchange rates, bond markets and such other financial instruments, led
to establishment of a vibrant Treasury.
Another functional area of the Treasury is Banking and Trading books including hedging the
bank‟s balance sheet from ROI and foreign exchange rate fluctuations. The pricing of
treasury assets and liabilities products which form a core of the balance sheet, is very crucial
to the managing of the two sides of the balance sheet of the bank.
Treasury and its role in Banks

In order to understand treasury and its role it is essential to understand the Indian Financial
Market. Various constituents of the Financial Market are as given below.

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Call/Notice
T-Bills
Term
Money
Forex
Market
CD
Money
Market ICD
CP
Financial Bank
Markets deposits
and lending Repo
Commercial
Debt bill
Market Central
Govt
G-Secs
Mutual State Govt

Fund
Market
FI bonds
Capital
Market
PSU bonds
Insurance Bonds
market
Corporate
Securities
The treasury department of a bank deals with all market segments other than Insurance
segment and the deposit taking and lending operations of the bank.
The role of treasury in banks in India initially was to ensure maintenance of RBI stipulated

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cash reserve ratio [CRR], which mandates that a stipulated portion of defined liabilities
popularly known as Demand and Time Liabilities [NDTL] be kept with RBI as cash deposit
and similarly a portion of the NDTL be invested in notified securities [SLR] issued by the
Government of India, State Government or such other securities as notified from time to time.
In the foreign exchange market, the bank‟s treasury is restricted to handling trading activity
of the constituents of the bank and remittances.
With the opening up of the Indian economy the role and scope of treasury has increased
manifold. Today treasury plays an important role in not only managing liquidity but it also
acts as a profit centre, by playing the role of a trader and investor. Treasury connects core
activity of the bank [deposit accepting and lending] with the financial markets. In short,
Treasury plays an active role in Asset-Liability Management [ALM]. Thus the treasury
manager has a significant role to play in the overall functioning of a commercial bank. The
treasury management refers to the science of managing treasury operations.
The main role of treasury is planning, organizing and controlling cash assets to satisfy the
financial objectives of the organisation. Let us discuss in brief the major rolesthe treasury
manager needs to play-
1. To deploy and invest the deposit liabilities, internal generation and cash flows from
maturing assets for maximum return on appropriate maturities either current or forward
basis consistent with the bank‟s risk policies/appetite.
2. To fund the balance sheet as cheaply as possible taking into account the marginal impact
of these actions.
3. To assess, advise and manage the financial risks associated with the non-treasury assets
and liabilities of the bank.
4. To take advantage of the attractive trading and arbitrage opportunities in the bond and
forex markets.
5. To effectively manage the forex assets and liabilities of the bank.
6. To manage and contain the treasury risks of the bank within the approved and prudential
norms of the bank and regulatory authorities.
7. Lastly to adopt the best practices in dealing, clearing, settlement and risk management in
treasury operations.
Thus the goal of treasury management is to maximize the return on the available cash
balances or minimize the interest burden or mobilise resources for ventures, assist corporates
in their domestic or overseas ventures.
Responsibilities of treasury including ALM

Treasury operations of a commercial bank consist mainly of two major functions-
1. Ensuring strict compliance of RBI guidelines with respect to CRR and SLR.
2. Liquidity management in the bank‟s balance sheet by-

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a) Ensuring optimum utilisation of available resources through proper investments.

b) Raising additional resources required for meeting credit demands at a reasonable cost.
c) Managing Market and Liquidity risk in every transaction.
After the integration of treasury operations i.e. domestic and foreign exchange, treasury
operations also includes providing cover to customers in respect of their foreign exchange
exposure and extending products and services to its customers for hedging interest rate risks.
The responsibility of treasury lies effective internal and external interface. Responsibilities
includes management of balance sheet, liquidity, reserves, funds, investments and managing
requirements of capital as per Basel norms, transfer pricing, technology and operations, risk,
trading activities and offering hedge products.
Assets Liabilities Management (ALM)

Assets Liabilities Management means management of the bank‟s balance sheet consisting of
assets and liabilities, to maximize stake holders earnings through high returns on money
deployed in assets with safety and liquidity in mind.
Broad objectives of ALM are-

1. To make available funds at a competitive price, as and when required. The task is to
achieve a proper mix of funds so that availability of funds to meet any eventualities is
ensured.
2. Sequencing of assets and liabilities over different time bands and keeping control on their
pricing by limiting their exposure to interest rate risks are things to be looked at in the
ALM Process.
3. To see that the rates paid and received on the liabilities and assets should be such that the
spread or net interest income is maximum.
The above objectives are to be accomplished without exposing the bank to default risk. To
ensure this, a three pronged strategy is employed-
1. Spread management: Spread or difference also known as interest spread or interest
margin or net margin/ spread or even net interest income refers to the difference between
interest earned on deployed funds and interest paid on the mobilised resources.
Spread maximization strategy involves-
a) Stabilizing earnings over the long term and making efforts to reduce bank‟s exposure
to cyclical rates.
b) Predicting rate changes and planning for such eventualities.
c) Co-ordinating rate structure.
d) Balancing default risk on loans and investments against probable benefits.
e) Ensuring a steady but controlled growth as also gradual increase in profitability.
2. Gap management: The difference between assets and liabilities that can be impacted due
to changes in the interest rate factor is referred to as Gap and such assets/ liabilities are
called as Rate sensitive assets [RSA] and Rate Sensitive Liabilities (RSL) respectively.
For the purpose of Gap Management, assets and liabilities are distributed over different

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time bands/ buckets calling for-

a) Identifying and matching assets and liabilities over different time bands.
b) Optimizing earnings over a complete economic cycle without moving to an extreme
position during any one phase.
c) Building a mechanism to expand and contract assets/ liabilities in response to rate
cycle phases.
3. Interest sensitivity analysis: This is an extrapolation of the „Gap management strategy‟.
It is concerned with the analysis of the impact of interest changes on the bank‟s spread/
margin and resultant overall earnings.
The strategy includes-
a) Segregating fixed and variable interest rate components of the balance sheet.
b) Listing assumptions regarding rate, volume and mix of the projected portfolio.
c) Making alternative assumptions on the rise and fall in interest rates.
d) Testing the impact of assumed changes in the volume and composition of the
portfolio against both, rising and falling interest rates scenarios.
ALM needs to be proactive and commensurate with the business cycle of the Bank. To ensure
that the ALM process is executed successfully, every bank has to keep in mind market
situations.
The scope of Asset Liability management [ALM] must be spelt out clearly. It has the purpose
of formulating strategies, directing actions and monitoring implementation thereof for giving
a shape to the assets and liabilities side of the bank‟s balance sheet, which will contribute to
the attainment of the bank‟s accepted goals.
It is recognized that ALM addresses to the managerial tasks of planning, directing and
monitoring. The treasury department undertakes operational tasks of executing the detailed
strategies and actions.
Structure of Treasury
The Treasury Department functions from an independent premises normally as a specialised
branch and under the direct control of the Head Office. This Unit functions with a degree of
autonomy and its own accounting system. The Treasury department can undertake domestic
and foreign exchange transactions and can directly participate in the clearing and settlement
systems.
The Treasury division is headed by a very senior officer of the Bank. The Treasury head
directs, controls and co-ordinates the activities of the department. The head also co-ordinates
the work between the Chief Dealer and the Head of Back Office.
Organisational structure of the treasury department of a commercial bank should facilitate

handling of all market operations, from dealing to settlement, custody and accounting, in both

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domestic and foreign exchange markets. In view of the complex nature of work and to have
better checks and balances, the functional role is divided into three divisions-
Sr. Nature of Nature of Work
No Division
01 Front Office Dealing and Investment – Risk Taking
02 Mid-Office Risk Management and Management Information System [MIS]
03 Back Office Deal confirmations, Settlements, Accounting and
Reconciliation
It is important that the above three functions are distinct and work in water tight
compartments. For example, dealers are not to handle settlement of accounts, the back office
should not perform dealing but may perform accounting functions – accounts section is one
part of back office which comprises several sections which handle separate functions.
Integrated Treasury
In many banks the functions of foreign exchange and domestic treasury are combined under
one roof for better coordination and efficient management. It is called an integrated treasury.
In some banks however, the domestic and foreign exchange treasuries function
independently. The functions of the three divisions of the treasury detailed below are for
integrated treasury.
1. Front Office: It is called Front Office or Dealing Room. The Division is headed by a
Chief Dealer. The Chief dealer is in charge of the division.
Working under the Chief dealer are other dealers. Each dealer will have specialisation i.e.
each dealer will handle either foreign exchange market, domestic market or securities
market. The Forex dealer will engage himself in buying and selling foreign currency in
the markets. However, all Dealers are trained to handle all types of markets.
Depending upon the size of the Bank, various other posts like Forward Markets,
Derivatives, and Corporate Dealer will be created for smooth functioning of the division.
Again depending on the requirements, banks may have separate Assets Liabilities
Management Desk to cater to the need of the Bank including a Head for a Research
Division.
The front office of a treasury has the responsibility to manage investments and market
risks in accordance with the instructions received from the Bank‟s Board through ALCO
Division.
The Dealing Room is not only the bank‟s centre point for international and domestic
financial markets activities, but also the centre for market and risk management activities
in the bank.
In order to have functional autonomy and also smooth functioning of the Dealings

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Department due to its complexities, significant authority is given to the Treasurer and the
Dealing Room staff to commit the bank to market. In view of this, strict control over the
activities of the treasury and its staff are critical to ensure that the bank is protected from
undue market risk.
The securities market being a large market, is normally divided into two parts i.e. Primary
and Secondary Markets.
The Securities dealer will deal only in the secondary market which is a market for already
existing securities and the sale and purchase of securities will be through an established
market mechanism. The dealer may also bid on behalf of the Bank as and when
Government Securities, T-Bills are auctioned by RBI. Depending upon the business of a
bank, there may be a separate dealer for Equity dealing who will participate in secondary
markets for sale/ purchase.
Primary market refers to fresh issues of Non-Government debt-paper by Corporate

Customers [mostly placed privately with qualified institutional investor]. The Primary
market issues are subscribed by Investment Dept., and they are handled outside the
Dealing Room, though they are part and parcel of Treasury operations. The reasons being
that such new issues approaching the market require appraisal of credit risk, proper study
of the issue terms and documentation to secure the debt. Normally such issues require
proper study and research either from the bank‟s own research team or from published
material.
Whenever primary issues hit the market, and the treasury is of the view that the bank
should invest in the issue, a note is placed before the committee, recommending purchase
of the equity shares based on parameters fixed by Board for subscribing to such issues on
behalf of the Bank.
2. Mid Office: The Mid-office is set up exclusively to provide information to the

management and to implement risk management systems. The Mid-office assists the
management in setting up the exposure and stop loss limits for the treasury and monitors
the limits so set up, on a day to day basis. At regular intervals MIS is generated and
performances of dealers/banks under key parameters are made available to the top
Management. Some other functions that the Mid Office handles are as follows.
 Transfer Price Mechanism.
 Calculating and reporting VAR (Value at Risk).
 Research – assessing likely market movements.
 Marking open positions to market to assess unrealized gains or losses.
Generally the Division reports to Head of Treasury or to Chief Risk Officer or such other
key authorities nominated by the Board, to ensure compliance of Treasury with Risk
Management policies and processes objectively.

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3. Back Office: The responsibilities of the staff of the back office are to verify and settle all
the deals concluded by the Dealers. The deals are counter checked based on the deal slips
prepared by the dealers as also confirmation received from the counter parties. The staff
attached to this Section confirms the deal independently with the counter parties over
phone and verify the authenticity of the confirmation received from the counter parties.
The Back office takes care of all accounting entries, as also submission of control returns
to the RBI. Back office takes care of the funding of the Nostro account - advises the front
office the latest funds position in Nostro accounts to enable them to take decisions
regarding surplus/shortfall of funds. It also maintains the security account with the RBI,
De-mat account with Depository Participants and ensures that adequate margin money is
maintained with Clearing Corporation of India for all Rupee and Dollar denominated
settlements carried out by dealers.
Settlement refers to receipt and payment of amounts based on deals made by the Dealers
during the course of the day. Settling the deal is the main function of the Back Office as
all payments and receipts must take place on value date. Any delay in settling the deal
attracts penalty for such delayed period and also mars the reputation of the Institution.
In view of the sensitive nature of role played by Front Office and Back Office, it is
mandatory that the staff in both these sections reports to two separate Managers.
Summary of Basic Treasury Functions

Domestic Operations Forex Operations
1. Maintenance of statutory reserves 1.Merchant dealing
2. Managing liquidity 2.Proprietary trading and arbitrage
3. Profitable deployment of surplus funds 3.Forex derivatives dealing
4. Trading and arbitrage 4.Managing overseas investments and
5. Hedge and cover operations borrowings
6. Mid Office/back office functions 5.Hedging of forex risks - proprietary
and for the constituents
6.Mid and back office functions
SGL and Constituent SGL accounts

The Subsidiary General Ledger (SGL) is the de-mat facility for government securities
offered to Commercial Banks and Primary Dealers by the Reserve Bank of India. It is a
system wherein Government Securities purchased by the Bank is held electronically by the
RBI.
Transactions in the SGL account

1. The Bank having the SGL account with RBI, should necessarily maintain a current

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account with RBI.

2. All transactions in Government Securities for which SGL facility is available, should
be routed through SGL account only.
3. Commercial Banks issuing SGL transfer form to another bank should ensure
beforehand whether there is sufficient balance in the SGL account. Under no
circumstances, should the transfer form issued bounce back for the reasons that
sufficient securities are not available in the account.
4. The purchasing bank should issue cheque to the selling bank only after receipt of SGL
transfer form from the selling bank.
5. The SGL transfer form should be in the format prescribed by RBI and should be
printed on semi-security paper of prescribed size. It should contain a running serial
number and there should be a control system in place to account for each such transfer
form issued.
6. SGL form should be signed by two authorised officials of the bank, whose signature is
already filed with the Public Debt Office [PDO] at RBI and other banks.
7. The SGL transfer form received by the Purchasing Bank from the Selling Bank should
be sent for transfer immediately. Under no circumstances the said SGL transfer form
should be resold to other bank as it valid only for one single transaction and is not
transferable/ negotiable.
8. Should any SGL transfer form bounces back, the purchasing bank should bring it to the
notice of RBI immediately.
Constituent SGL accounts

Distinct SGL accounts are held by the main SGL account holder on behalf of its clients.
Therefore SGL account holders can have two SGL accounts with the RBI:
1. SGL account No.1.
2. SGL account No.2.
SGL account No.1 is the account for the commercial Bank for its own holdings. It is a
direct account i.e. can be operated by commercial bank with RBI. SGL account No.2 is the
account for commercial Bank‟s constituents i.e. those who are not eligible to open SGL
account in their name with RBI.
Such entities for example a Provident Fund Trust, which is not eligible for an SGL account
can hold and trade in securities in de-mat form by opening a constituent SGL account with
a commercial bank. However, as and when debits and credits are made to this CGSL
accounts, the RBI may be suitably advised before settlement.
Introduction to the investment portfolio of a domestic treasury

Hitherto the function of the Treasury was confined to funds management i.e. maintaining
cash balances to meet day-to-day requirements and in the process deploying surplus funds
generated in the operations and sourcing funds to bridge occasional gaps in the cash flow.

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Thus the function of the Treasury was essentially liquidity management.
Due to liberalisation and globalisation of the economy, newer instruments have been added
to the domestic market and scope of treasury operations has been widened.
Treasury assets are marketable or trade-able subject to meeting legal obligations such as
payment of applicable stamp duty or such other levy may be of local government or central
government as the case may be.
An illustrative list of domestic treasury instruments/products are-

1. CDs, or Certificate of Deposit.
2. Statutory Liquidity Bonds or SLR Bonds.
3. Non-SLR Bonds.
4. CP or Commercial Papers.
5. G-Secs means Treasury Bills, Government securities may be central/state govt.
6. Repo (Repurchase Agreements).
7. Reverse Repo
8. CBLO
9. Call/Notice Money
10. Term Money
11. Interbank Deposits
12. Equity Shares.
Fixed Income Money Market and Derivatives Association [FIMMDA]

Fixed income securities are instruments wherein the total return to the investor is fixed for
the tenor of the instrument. They are tradable securities which carry a fixed rate of interest
payable periodically which is referred to as coupon and the amount payable on maturity
called the Redemption Amount is also fixed. However, if the investor decides to sell the
security in the market during the life of the security, the return may be more or less than
the coupon depending upon the prevailing market rates for the security concerned.
Examples of such securities are SLR Securities and Non - SLR Securities.
These securities can be traded over an electronic platform known as Negotiated Dealing
System (NDS) or over an Over The Counter Market (OTC Market). Now the NDS
platform automatically pairs matching sell and buy orders placed by the market players - it
is referred to as NDS-OM (Order Matching).
The association of players in the fixed income money market instruments is called
FIMMDA. It ensures orderly conduct of the fixed income money market operations by
laying down rules and code of conduct.
Government of India in consultation with the RBI has decided that all SGL/CSGL account

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holders should adhere to the FIMMDA code of conduct while executing trades Negotiated
Dealing System – Order Matching [NDS-OM] and Over the Counter Markets [OTC
market].
Accordingly the RBI in coordination with FIMMDA and market participants developed
and implemented a code of conduct for users of NDS-OM and other systems and in order
to implement these guidelines RBI in exercise of powers conferred under section 29(2) of
the Government Securities Act, 2006 issued the instructions contained in RBI circular no.
IDMD.DOD.No.06/10.25.66/2012-13 dated December 06, 2012.
Role of FIMMDA
Code of conduct for transacting in Government securities using NDS–OM system/
OTC markets and rules for Dispute resolution Committee [DRC]:
1. Objective: This Code of Conduct, hereinafter referred to as the “Code”, seeks to lay
down directives to the users of NDS-OM system, so that the anonymity, ease of dealing
and settlement, provided by the System are utilized properly. The code attempts to
prevent improper utilization which leads to misleading or misinformation to the market
participants resulting in losses (sometimes very large) and undue enrichments.
2. Transactions covered: The code is for all the transactions in Central/State

Government Securities(G-Secs) and Treasury Bills (TBs) done in marketable lot on
[NDS-OM] system and also transactions done in the Over the Counter [OTC] market
and reported in NDS-OM for settlement. DRC may consider transactions not covered
above and/or in other segments depending on merits of individual case. DRC will
record the reasons for considering/ rejecting a claim.
3. Applicability: The code is applicable to all participants who deal in Govt. securities on
NDS-OM or in OTC market and reported on NDS-OM reporting platform.
4. Systemic Code: Users of the system shall observe high standards of integrity and just
and fair principles of trading while trading either on their own account or on behalf of
their clients. Users are required to use the security features inbuilt in the system. They
should appreciate the features such as Price/Yield Range Settings, high–speed trading
and Straight Through Processing (STP) for settlement which the system provides, and
the fact that by ignoring the in-built security features, the users are susceptible to
committing „costly‟ mistakes.
Bids/Offers placed on the System, should be free from market manipulation and
fraudulent practices.
Examples of such manipulated/ fraudulent bids and offers are as under-

a) Entering into arrangements for sale or purchase of a Government security where
there is no change in beneficial interests or market risk or where the transfer of
beneficial interest or market risk is only between parties who are acting in concert

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or collusion.
b) Deliberately trying to manipulate the prices of infrequently traded securities at
monthly/quarterly/annual closing dates.
c) Doing a „routing deal‟ i.e. purchasing a security at the instance of a third party who
does not have funds to purchase the security, with an unwritten agreement to sell
the same to the third party on a later date at a predetermined price which may not
be market related.
d) Deliberately putting wide bids and offers on the NDS-OM for the frequently traded
securities, such that the party buying or selling at the price displayed commits a
“Big-Figure” mistake.
5. Erroneous Trades and Reversal-Role of DRC:

Erroneous Trades: Following are examples of erroneous trades which will be
considered by DRC for reversal or otherwise. These are also referred to as Big-figure
mistakes in market parlance. But to ensure market integrity, DRC may consider claims
which may not fall in any of the categories described below, on merits. Such decisions
will be recorded with reasons.
For Central/State Government securities the bid and offer is put in terms of price:
a) Big-Figure mistake in Price while buying: An offer is either deliberately or
erroneously put at ₹91.56 or ₹91.55 for a security that was last traded at ₹90.56.
Once the offer is hit by mistake without realizing the change in the big figure, it
would be considered as a “Big-figure” mistake by the buyer. The market, however,
reverts to bids and offers at around ₹ 90.56 after the erroneous trade. It is an
erroneous trade even if the bid is erroneously put by the buyer at ₹91.56 and the
same was hit by a seller.
b) Big-Figure mistake in Price while selling: A bid is either deliberately or
erroneously put at ₹89.56 or ₹89.57 for a security that was last traded at ₹90.56.
Once the bid is hit by mistake without realizing the change in the big figure, it
would be considered as a “Big-figure” mistake by the seller. The market, however,
reverts to bids and offers at around ₹90.56 after the erroneous trade. It is an
erroneous trade even if the offer is put erroneously by the seller at ₹89.56 and the
same was hit by a buyer.
c) For T-Bills the bid and offer is put in terms of Yield.
d) Big-Figure mistake in Yield while buying: An offer is either deliberately or
erroneously put at 7.70% or 7.75% for a T-Bill that was last traded at 8.70%. Once
the offer is hit by mistake without realizing the change in the big figure, it would be
considered as a “Big-figure” mistake by the buyer. The market, however, reverts to
bids and offers at around 8.70% after the erroneous trade. It is an erroneous trade
even if the bid is put erroneously by the buyer at 7.70% and the same was hit by a
seller.
e) Big-Figure mistake in Yield while selling: A bid is either deliberately or
erroneously put at 9.70% or 9.65% for a T-Bill that was last traded at 8.70%. Once
the bid is hit by mistake without realizing the change in the big figure, it would be

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considered as a “Big-figure” mistake by the seller. The market, however, reverts to

bids and offers at around 8.70% after the erroneous trade. It is an erroneous trade
even if the offer is put erroneously by the seller at 9.70% and the same was hit by a
buyer.
f) Inversion errors: (putting yield in place of price and vice-versa) The bid and offer
for Central/State Government securities are to be put in terms of Price. The bid and
offer for T-Bills are to be put in terms of Yield. If yield is put in place of price and
vice-versa and the other party hits the same that will result into an erroneous trade.
For example, suppose the last traded price and yield of a G-sec were ₹88.29 and
9.02% respectively. An offer to sell that security is erroneously put at ₹9.02 or
₹9.03 and if the same is hit by a buyer that will also result into an erroneous trade.
g) Error due to wrong selection of securities: The dealer while putting a „bid‟ or
„offer‟ or while „taking‟ or „giving‟ a security appearing on the trading screen, may
select a wrong security which is either above or below the security he/she intended
to transact. Such type of wrong selection of security may result in a trade at „off
market‟ price. If the difference between the price of the security intended to be
traded and actually traded is distinctly outside the normal price movements of the
security traded, then it will be considered as an “Erroneous Trade”.
h) However, in the above examples, if the market continues to trade one Big-Figure
higher or lower, after the first Big-Figure change deal (on account of some market
event), the first Big-Figure change deal and the subsequent deals would not be
considered as Big-Figure error deals. The decision of DRC will be final in
determining such errors.
“Market Makers” are expected to open the market with narrow bids and offers, unless
there is an event warranting wider spreads. Placing a wide bid/offer at the start of the
day, without an event warranting wider spreads would also constitute as misleading the
market to commit Big-Figure mistakes.
At times of market events, the “Market Makers” may quote wider spreads but the bid
and offer quotes should not be ones that will seemingly mislead the market to commit
Big-Figure mistakes.
At the same time, the “Market Takers” are expected to be more cautious while dealing
at opening prices, which are wide and more so when they take the offers by overriding
their own internal “Pop up Alerts”.
Whether the Big-Figure mistake is due to putting bid or offer either deliberately or
erroneously, the trade will be „Erroneous Trade‟.
6. Composition of Dispute Resolution Committee (DRC):

An independent and well represented committee consisting of a total of ten
representatives from:

P a g e | 16
a) Private Bank (presently Axis Bank Ltd) -1

b) Foreign Bank (presently Standard Chartered Bank )- 1
c) Public Sector Banks (presently SBI and IDBI) - 2
d) Co-operative Bank (presently Saraswat Co-operative bank) - 1
e) Insurance Company (presently LIC) - 1
f) Primary Dealers (presently SBI DFHI, I-SEC PD, STCI PD) -3 and
g) Mutual Funds (representative from AMFI/nominated by AMFI- presently the Dy.
CEO of AMFI) - 1.
The Organizations concerned will nominate two representatives to function as
members, one primary and another to act in case the primary member is unable to
attend the meeting, whatever may be the reasons.
The DRC committee will function for one year from 1st October to 30th September of
the next year. Every year in the month of September, a new body will be reconstituted
by the FIMMDA Board. For any reason, if there is delay in such formation, the existing
committee will continue till formation of a new committee.
7. Reporting of Erroneous Trades to FIMMDA:

a) Any market participant who notices an “Erroneous Trade” as described above or a
bid or offer that may lead to a “Big-Figure Mistake” or “Erroneous Trade” may,
though being a third party not involved in the bid/ offer/ trade, report the same to
FIMMDA either telephonically or through e-mail in the prescribed format.
b) The party who has gained due to a “Big-Figure Mistake” or “Erroneous Trade”
should immediately inform FIMMDA about such a deal either telephonically or
through e-mail in the prescribed format.
c) The party who has lost due to a “Big-Figure Mistake” or “Erroneous Trade” should
lodge a claim/ dispute with the Dispute Resolution Committee through FIMMDA
by e-mail. The claim should come from the Head of Treasury (HOT) in the
prescribed format.
8. Lodgement of claim: The claim should be lodged as early as possible but not later than
12:00 Noon on the Settlement Date. If the claim is received subsequently, the DRC
may entertain the same on merits in exceptional cases and to protect market integrity.
Settlements in such cases are subject to approval by the relevant authorities/platform
owners.
9. Procedure for reversal of “Erroneous Trades”:In case “Erroneous Trades/ Big-

Figure mistake trades” get executed, the following procedure should be adopted to
ensure that no undue enrichment and/ or losses occur to either of the counterparties:
a) When an „Erroneous Trade” is reported to FIMMDA either by a losing party or
gaining party or by a third party, FIMMDA shall convene a meeting of the DRC or
arrange for a discussion through conference call.
b) If DRC is convinced that the deal is an “Erroneous Trade” and there is a case of

P a g e | 17
reversal, FIMMDA will seek the counterparty name/s from RBI.

c) In cases where the “Erroneous Trade” is very much obvious, FIMMDA may
without waiting for any claim, refer the matter to DRC and if agreed upon, may
seek names of counter parties from RBI and place the matter before the DRC along
with counter party names for decision.
d) The DRC will hear both the counter parties and then decide as to whether the
“Erroneous Trade” is to be reversed and convey the decision to both the parties
concerned. If the DRC feels that there is no case for “reversal”, the losing party will
be informed accordingly.
e) Bilateral reversal: Sometimes, both the buyer and seller of an erroneous trade might
be reporting to FIMMDA and may seek/ agree to reverse the trade voluntarily. In
such cases, FIMMDA will prima facie verify the details of the trade like trade no,
time etc. and if satisfied, may approach RBI directly for revealing the counter party
names and if the details match with the counter parties details, may allow them to
reverse the trade. DRC members and RBI will be kept informed of the trade and its
reversal.
f) Other cases: As all types of disputes which may arise may not be envisaged, the
DRC will have the powers to decide any other case that is NOT described in the
foregoing paras “on merits” to keep orderly markets and maintenance of market
integrity. DRC will however record reasons for such decisions. These will be
available on website for public information.
g) RBI will be informed of all cases referred to them and the decision of the DRC in
the matters.
h) As far as possible, a reversal deal should be done outside the NDS-OM through
OTC and put through on the same day, on the NDS-OM Reporting platform, for the
same security, same amount (face value), and at the same price.
i) In case this is not possible for any reasons; the difference should be settled in cash
the next day at the rates mentioned below (in the order of preference):
 The rate mutually agreed to between the counterparties; or
 The current market rate; or
 The rate decided by the DRC by way of a poll (Poll will be taken from the
Dealers of the DRC member organizations and a simple average is calculated
and informed to both the counter parties.
j) Both the counterparties should inform FIMMDA about the reversal transaction on
the same day latest by 6.00 pm. In respect of cash settlement on the next day, the
same should be informed to FIMMDA at the earliest, but not later than the market
closing hours on the same day. In case of any specific problems for reversal, DRC
will suggest the methodology to be adopted for reversal.
The above reversal methodology is for erroneous trades done on the NDS-OM. On the
other hand, such erroneous deals, if done over the Voice–based system (OTC) should
be corrected by entering into another OTC deal and reported on the NDS-OM reporting
platform.The decision of DRC will be binding upon all parties.

P a g e | 18
10. Fees: FIMMDA reserves the right to levy a fee as handling charges and to frame rules
for the same as approved by its Board with a reasonable advance notice.
11. Violation of Code of Conduct: As any violation of Code of Conduct would be viewed
seriously, it is expected that all users will strictly adhere to the Code of Conduct in
letter and spirit.
The function of the Treasury till 1990s was to manage funds i.e. maintaining adequate cash
balances to meet day-to-day requirements, deploying surplus funds generated in the
process and sourcing of funds to fill the shortfall if any during the course of the day
including see to it that RBI directive of maintaining CRR and SLR is done with and there
is no default in the management of the same. In a nutshell, the function of the Treasury
Division was to maintain Liquidity Management.
With the integration of the money market, foreign exchange market and securities market
into one Unit, the functions of the Treasury increased from a mere CRR/SLR keeper to a
full-fledged Treasury.
Unit summary
The key learning in the unit have been:
 Introduction to Treasury.
 Treasury & its role in Banks.
 Responsibilities of treasury including ALM.
 Structure of Treasury, Front, Back and Mid Office.
 SGL and Constituent SGL Accounts.
 Introduction to Investment Portfolio of a Domestic Treasury.
 Role of FIMMDA (Fixed Income Money Market and Derivatives Association).

Nitte Education International
Post Graduate Diploma

(Banking & Finance)
Foreign Exchange, Treasury

and Market Risk
Management
Unit 2
Page |1
Introduction
“NEIPL”.

Page |2
Unit 2
Treasury risk management-
 Treasury settlements - dealing and settlement systems.
 Internal control - accounting and control.
 MIS and reporting.
 Control limits.
Introduction
Bank managements are highly sensitive to treasury risks as the potential losses could be
huge and the losses materialize in a very short time (unlike credit) and the transactions
once confirmed are irrevocable hence no corrective action is possible particularly in
foreign exchange market. Most treasury activities predominantly involve high degree of
market risk than credit risk.
Treasury risk management

Risk profile of the treasury activities consists of two broad categories-
1. Financial risks: Credit risk, market risk and liquidity risk.
2. Operational risks: Systemic risk, compliance risk, legal risk etc.
For mitigation of such risks, various prudential guidelines have been prescribed by regulators
and by bank managements which are to be scrupulously followed. The prescribed controls
and supervisory measures are mostly in the nature of preventive steps and can be classified
as-
1. Organizational control.
2. Exposure ceilings.
3. Limits on trading positions and stop loss limits.
NDS and DVP systems have been developed to ensure that parties to a trade do not suffer
losses on account of failure of the counter party to pay or deliver on time. Other electronic
trading platforms have also been developed to facilitate trading and dealing.
Settlement of a deal in an efficient manner is part of the whole process of risk management in
dealing operations. Systems and procedures have therefore, been put in place to ensure
efficient settlements.
Another method of managing risk in treasury operations is to put a check on the amount of
risk that dealers can expose the bank to during the course of their work. This is done by
adopting certain accounting policies and procedures apart from accounting for the balance
sheet purpose and prescribing various exposure limits within which the dealers have to
operate.

Page |3
Trading platforms
As already mentioned NDS and DVP are trading systems developed to ensure that parties to a
trade do not suffer losses on account of failure of the counter party to pay or deliver on time.
Other electronic trading platforms have also been developed to facilitate trading and dealing.
These are means and methods to safety and minimize risks associated in trading and
settlement in treasury.
Negotiated Dealing System (NDS)

NDS is an electronic platform for facilitating dealing in Govt. securities and money market
instruments. Banks and primary dealers are obliged to become members of NDS. Its
membership is open to other participants in the securities/ money market who are also
members of INFINET and have an SGL account with the RBI. The system of submission of
physical SGL transfer forms for deals done has been done away with after implementation of
NDS.
NDS also provides interface to Securities Settlement System of Public Debt Office of the RBI
thereby facilitating settlement of transactions in Govt. securities.
Other Trading Platforms

Trading in other instruments is done electronically through networked computers. Market
players are part of a WAN and make bids and offers, be it forex, bonds or equities. The
system electronically matches bids and offers. Current examples of electronic trading
platforms are those of NSE, BSE and foreign exchange (through Reuters Electronic Dealing
System)
Straight Through Processing (STP)

This electronic system enables trading, documentation, clearing, settlement and custody on a
single, end to end hardware and software platform. Individual trades once approved and
authorised by the buyer and seller are automatically settled by the system through its
connectivity with the clearing house. Buyer receives the securities in their custodial (demat)
account and seller receives funds.
Treasury settlements
Domestic Treasury
Settlement of deals done in the domestic treasury is done through Clearing Corporation of
India Limited (CCIL). CCIL is an institution set up to clear outright and repo trades on a
guaranteed basis. Negotiated Dealing Settlements (NDS) is the trading platform while CCIL
is a clearing house for settling trades.
CCIL handles the following products-

1. Outrights.
2. Repos/ CBLOs.

Page |4
3. RBI auctions.
Outrights refers to buying and selling of securities between two participants directly.
The NDS/CCIL network spans the entire country. Deals can be logged into the NDS by banks
from anywhere through their connectivity to the RBI servers after which no manual
intervention by banks is necessary to complete the settlement.
Novation and Multilateral Netting

CCIL applies the concepts of novation and multilateral nettings in its operations. Novation
introduces CCIL as the intermediary responsible for clearing and settlement of trades
between two counterparties. In effect for settlement purposes, the counterparty to the bank
doing a trade with another bank is CCIL. CCIL takes the responsibility for delivery, making
and receiving payments to and from the counterparties for all transactions undertaken in the
OTC market and on the NDS-OM platform and INFINET (for forex).
Multilateral Netting Process nets out the sums payable and receivable by each member to
arrive at the net amount to be paid or received by the member.
CCIL guarantees settlement of all trades in Government securities. During the settlement
process, if any participant fails to provide funds/ securities, CCIL will make the same
available from its own means. For this purpose, CCIL collects margins from all participants
and maintains „Settlement Guarantee Fund‟.
Further to cover likely adverse price movements, participants have to keep a certain amount
with the CCIL as initial margin for performance of contracts. This margin can be in the form
of deposits or liquid securities and the amount varies from transaction to transaction. Apart
from this initial margin CCIL also demands mark to market margin if the prices move
violently. This kind of mark-up margins may be introduced by CCIL in some other forms
also depending upon market conditions. In case there is a short fall in margin requirement,
CCIL asks the bank concerned to make good the margin before settling the trade.
As a measure of risk management, delivery versus payment (DVP) system is followed by

CCIL at the time of settling trades. Once CCIL receives the trade information, it works out
participant-wise net obligations on both the securities and the funds leg. The payable/
receivable position of the constituents. CCIL forwards the settlement file containing net
position of participants to the RBI where settlement takes place by simultaneous transfer of
funds and securities under the „Delivery versus Payment‟ system.
In the next phase, settlement will move to Real Time Gross Settlement where securities and
funds will be settled on gross basis in real time like funds transfer happens under RTGS.

Page |5
Foreign Exchange Treasury

CCIL has also introduced a dealing and trading platform for forex called FX Clear. FX Clear
is similar in concept and operations to NDS and enables Straight Through Processing (STP)
once a deal is concluded.
FX Clear enables trading to be done both through order matching mode and negotiation
mode. Order matching mode automatically matches the best bids and offers in the system,
while the negotiation mode enables deals after agreement on prices, quantities etc. between
the counterparties. A Trade Cancellation facility has also been provided on the platform to act
as a safeguard from the dealers from erroneous trades getting concluded on the Order
Matching mode on the platform.
In the order matching mode the dealer can specify his parameters like minimum selling price,
maximum buying price, stop loss etc. and the system shall match the deals accordingly.
The Order matching mode of FX-CLEAR allows Spot trading in USD/INR currency pair,
whereas the Negotiation mode allows trading in USD/INR & major cross currency pairs
across all settlement dates which means that in Negotiation Mode of FX-CLEAR a dealer can
enter into CASH, TOM, SPOT, Outright Forwards, Deposits and SWAP deals in major
currency pairs which include USD/INR, GBP/USD, EUR/USD, EUR/INR, USD/JPY,
JPY/INR, GBP/INR, GBP/JPY, EUR/JPY etc.
Once a deal is put through using FX Clear, it is settled without any further action on the part
of the dealer or the back office. In other words it is a STP system.
Deal confirmation files are transmitted over the INFINET to CCIL, and form the starting
point for processing by it. The trades are validated and matched. Matched trades are subjected
to an online exposure check and trades that pass such exposure check are „Accepted‟ for
settlement. Novation occurs at the point in time when the trade is accepted for guaranteed
settlement. Following the multilateral netting procedure, the net amount payable to or
receivable from CCIL in each currency is arrived at, member-wise. A Settlement window of
five hours (i.e. 2:30 p.m. to 7:30 p.m.) is defined. Within this window, the settlement is
effected. The rupee leg is settled through the member‟s current accounts with RBI and the
USD leg through CCIL‟s account with the Settlement Bank. Settlement happens on a
Payment versus payment basis (PVP) i.e. the final settlement of one obligation occurs if and
only if the final settlement of the linked obligation occurs. Various reports are generated to
update members on the status of deals reported by it to CCIL and the net settlement
obligations that become due to and from them. These reports are accessed by members over a
Report Browser.
For using FX Clear it is also essential that a bank is a member of INFINET which covers the
entire country.

Page |6
In case of FX Clear, the CCIL requires a margin of 4.5% of Net Debit Cap to be maintained
by the banks. Net Debit Cap for a bank is calculated after taking into account its net worth,
capital adequacy and other financial parameters. The bank`s short USD position (Oversold
position) should not exceed the net debit cap.
CCIL pays market related interest on the margin maintained by the banks.
Deals other than those cleared by FX Clear, are settled on bilateral basis between the
counterparties by transfer of funds from/to Nostro accounts using SWIFT communication
system.
Risk Management
1. Domestic Treasury
a) Treasury operations predominantly attract credit and market risks.
b) Credit risk is taken care of by DvP method.
c) Initial margin, mark to market margin and volatility margin enable CCIL to cope with
the market risk.
d) In the event of depreciation in margin, CCIL makes margin calls to the concerned
bank which has to be honoured by the bank within a specified time frame latest by the
next working day.
e) CCIL has also raised credit lines to put through the settlements if there are short fall
of securities or funds.
2. Foreign Exchange Treasury

a) As in the case of domestic treasury operations, the margins for forex settlements offer
almost full protection against market risk.
b) CCIL also has recourse to the defaulting bank`s RBI account for this purpose.
Internal control
The entire risk management process in treasury is based on data that is generated through
accounting transaction records. Therefore, it is necessary to put in place accounting policies
and procedures and ensure strict adherence thereto. Since treasury transactions are invariably
of high value, importance of accounting policies and adherence thereon to such policies is of
paramount importance.
A). Accounting - Domestic treasury

The investments portfolio of the bank which is handled by treasury is subject to market risk
as such investments are tradable in a highly volatile market. The accounting of such
investments therefore, is different from that for deposits and loans.
For the purpose of the balance sheet all investments will be accounted for at the cost of
acquisition or market price whichever is lower. However, for profit accounting, RBI

Page |7
stipulates that the entire investment portfolio of a bank should be classified into the following
three categories-
1. Held to Maturity (HTM).
2. Held for Trading (HFT).
3. Available for Sale (AFS).
The category in which an investment will be placed has to be decided by the bank at the time
of acquiring the security.
Profit Accounting
General Principles-
1. Interest on securities is paid at defined intervals. If a security is bought between two
interest payment dates, the accrued interest (Interest for the broken period) has to be paid
to the seller (since it will be received by the buyer on due date). Interest so paid has to be
treated as expense and accounted for accordingly.
2. Similarly accrued interest received when a security is sold should be treated as income
and accounted for accordingly.
3. Book value of the security purchased to be shown in the balance sheet will therefore, have
no element of interest. Similarly only book value of security sold will be debited for the
purpose of balance sheet.
4. Brokerages received are deducted from the cost of acquisition.
5. Brokerage paid is treated as expense.
6. All inter category transfers must be at the lower of the market price/ book value and
depreciation if any should be fully provided for.
Capital Charge
Banks are required to provide capital for market risk for HFT and AFS category.
Investments - Valuation of investments

HTM
 All investments in the HTM category are valued at acquisition cost. If the redemption
value is less than acquisition cost, the difference must be amortized over the years
remaining to maturity.
 HTM investments need not be marked to market.
 Marked to market indicates that if the current market price of a security is lower than the
acquisition price, the bank should make appropriate provisioning in the books of account.
HFT & AFS

 Individual securities in the HFT and AFS category must be compulsorily marked to
market.
 Appreciation in securities value is ignored while depreciation has to be provided for.
 Valuation is generally done at monthly intervals.

Page |8
Accounting and Provisioning Norms for Non-Standard Assets

1. An investment is classified as Non-Performing if interest /principal remains overdue for a
period of 90 days.
2. Income should not be recognized on assets classified as non-performing.
3. Non-performing assets have also to be classified as sub-standard, doubtful and loss as in
the case of credit.
4. Provisioning is also to be done as in case of credit.
B). Accounting – Foreign Exchange Treasury

The foreign exchange market is the most volatile of all the financial markets. While it offers
enormous opportunity for making profits, possibilities of suffering losses on account of
adverse movement of exchange risk are equally great. Therefore, it was necessary to evolve
adequate foreign exchange risk management systems.
The principal risk in foreign exchange transactions comes from adverse movement of
exchange rates. Therefore, it becomes necessary to keep a record of the amount that is
exposed to exchange rate movement and what could be the possible loss.
It is done by keeping records as given below-

1. Open position
Treasury transactions are buying and selling transactions. Therefore, in foreign exchange,
currencies will be bought and sold. In either case, the amount of currency bought or sold
will attract exchange rate fluctuation. For example, If USD 100,000 is bought at INR
64.50 today and tomorrow Rupee appreciates against the US dollar to 64.40 then the
value of purchase in Indian Rupee terms will fall. Similarly if the Rupee depreciates to
say 64.60, the value in Indian Rupee terms will rise.
Continuing with the above example, if there was a matching sale of USD 100,000 then,
whichever way USD/INR exchange rate may move, there will be no net effect on the
value of the two transactions put together in Indian Rupee terms. It therefore, can be said
that either purchase or sale of foreign currency for which there is no matching/
corresponding sale or purchase with same maturity, will be exposed to exchange rate
fluctuation.
All purchases/ sales made by the dealers are known as positions taken by them in that
particular currency and such purchase or sale positions which are not covered by a
matching/ corresponding sale or purchase, as the case may be, are called Open Positions.
For instance, in the above example, against a purchase of USD 100,000 corresponding
sale was of only USD 50,000 then the open purchase position in USD would be 50,000. It
is also referred to as long position. In case the open position is on the sales side it is
known as short position.
RBI directions say that effort should be made to keep the position square or near square.

Page |9
The management fixes currency wise and dealer wise limits for keeping open positions.
The back office of the treasury shall keep a record of all the open positions currency wise
and submit periodical reports to the management for control purpose. Following are
various open position limits that are prescribed by the management of the banks for the
dealers to operate within.
2. Daylight limit
Dealers, to take advantage of the volatility in the market, may initiate deals during the
course of the day and also, invariably, close them also during the course of the day.
Therefore, the bank will be exposed to risk to the extent of open position – long or short –
during the period for which the deal remains outstanding. The banks fix a limit for such
kind of exposure and it is called day Light limit. The dealers cannot breach this limit
while initiating deals during the course of the day.
3. Overnight limit
If the dealer/ bank decides not to close a position at the close of the trading, it has to be
carried over to the next day. Such positions that are open through the night are known as
Overnight positions and the bank fixes limit for such exposures also. All overnight
exposures carry 100% risk weight therefore; these limits are generally small compared to
the daylight limits.
4. Gap Limit
While squaring deals, it is not always possible to exactly match the maturities also e.g. the
bank may have 100,000 long USD/INR position for three months and 100,000 short six
months USD/INR position. There is no open position but cash flows from the two deals
will happen at two different dates. This results into risk which is called Gap Risk or
Liquidity Risk.
To manage such risks, banks take control measures by fixing limits such as-
a) Individual Gap Limit (IGL) – a monthly gap limit for each currency.
b) Cumulative Gap Limit – for all maturities for each currency which would be less than
the total of monthly gap limits.
c) Aggregate Gap Limit – Sum total of the gaps in each currency arrived at by adding
gaps in each month ignoring the plus or minus sign. In cumulative gap limit
mentioned above, the monthly gaps are added considering plus and minus signs. It is
therefore, net gap cumulative position whereas Aggregate Gap Limit is the gross gap
position.
d) Cumulative Gap Limit for all currencies put together which would be less than the
total of cumulative gap limits for each currency.
Limits common to Domestic and Foreign Exchange Treasury

1. Stop Loss Limit: Stop loss is a limit that acts as a safety valve if something starts to go

P a g e | 10
wrong with a trade or a position. It is the amount up to which a trader/ dealer may incur in
a trade/ deal if the market moves against him. If the stop loss limit is triggered, the
concerned trade/ deal/ portfolio must be unwound/ closed out compulsorily.
2. Individual Dealer’s Limit: The scope of trading/ taking position by a dealer is restricted
by putting limits at individual dealer level. This kind of a limit puts a cap on the extent to
which an individual dealer can expose the bank to market risk.
Another important concept in treasury operations is Value at Risk
Value at Risk (VaR)

VaR is measure of loss that might occur due to maintaining an open position in a volatile
asset. For example if a bank maintains a 2 million overbought open position in USD acquired
at a cost of say ₹ 68.50 the funds outlay would be ₹ 137 lakh. Assuming, foreign exchange
being a volatile asset, the Rupee appreciates by ₹ 0.50 per USD the value of the risk in
carrying this open position would be ₹ 0.50 * 20,00,000 = ₹ 10,00,000. This is known as
value at risk or VaR.
Therefore each bank calculates their aggregate gap every day and calculates the VaR.
VaR is calculated using statistical models on the forecast for likely change in the exchange
rates/ value of securities which in turn is based on past data.
VaR is stated as a certain percentage of banks portfolio at a certain confidence level. VaR at
99% confidence level implies 1% probability of the stated loss. Further VaR is always
calculated for a given period of time and expressed as percentage of a portfolio or as an
absolute figure. Therefore, a VaR of ₹ 10,00,000 or 1% at 99% confidence level for one week
for an investment portfolio of ₹ 10,00,00,000 means that market value of the portfolio is most
likely to drop by a maximum of 10,00,000 with 1% probability over a period of one week or
99% of the time the value of the portfolio will stand at or above its current value.
Calculating and monitoring VaR of banks investment portfolio and aggregate gaps on a daily
basis therefore, serves as an effective tool for market risk management.
Further aimed at management of treasury risks there are some control and reporting systems
in place.
Control and reporting

Key aspects in control and reporting are-
1. Banks have an Asset-Liability Management Committee (ALCO) which manages gaps,
interest rate, liquidity and interest rate risks of the treasury and non-treasury balance
sheets.
2. Banks are required to send monthly reports to their boards and RBI covering liquidity
mismatches and interest rate sensitivity.

P a g e | 11
3. The investment committee reviews the investment portfolio at half yearly interval with
emphasis on rating migration and portfolio quality.
4. Banks undertake concurrent audits of securities and funds management transactions. The
reports of the auditors are put up to the audit committee of the board every quarter.
5. The treasury is subject to periodic inspection.
6. Risk based internal audit system as per guidelines issued by the RBI have been put in
place by the banks
7. The software package used by the treasury is system audited at regular intervals to test its
ability to cope up with new products and instruments.
8. Defaults/ arrears in interest/ principal on investments are monitored and reported to the
appropriate authorities.
9. The functions of front office, mid office and back office are completely segregated.
10. Deals are backed by deal slips and office memos containing approvals by the competent
authority.
Treasury operations result in high profits but they can also lead to huge losses therefore, they
have to be controlled and monitored on a regular basis. Effective accounting policies have to
be adopted to ensure that correct value of the treasury portfolio or position is known all the
time. Also, adequate risk management policies and procedures have to be adopted to
minimize the possibility of loss. Since treasury products are subject to market risk all the
time, operational freedom of the dealers/ traders is curtailed by fixing suitable limits for
minimizing the loss that may occur due to the market moving against the dealer or trader.
The Reserve Bank of India has set up regulatory framework for controlling and monitoring
treasury operations of the banks which has to be scrupulously followed and required
reporting has to be done to them as per schedule.
Unit summary
Treasury risk management-
 Treasury settlements-dealing and settlement systems.
 Internal control-accounting and control.
 MIS and reporting.
 Control limits.


(Banking & Finance)

and Market Risk
Management
Unit 3
Page |1
Introduction
“NEIPL”.

Page |2
Unit 3
 Overview of treasury instruments - Treasury bills, bonds, CDs, CPs, Repo and reverse
repo, gilt edged securities, Hedging products.
 Domestic and Forex Treasury.
Introduction
The basic function of the money market is to provide efficient facilities for adjustment of
liquidity positions of players in the market. It meets short term requirement of the
borrowers and provides liquidity to the lenders. An efficiently functioning money market
promotes flow of funds to the most important uses throughout the nation and the world and
across the full range of economic activities thus stimulating economic growth. This flow of
funds happens through the use of a number of financial instruments that are bought and
sold in the money market. They are usually of one year or less duration. Each instrument
serves a specific purpose and has defining features. Since treasury departments of banks
deal with these instruments they are also called the treasury instruments.
Since the treasury instruments are bought and sold in the market at prevalent market rates,
they suffer from market risk. Therefore, it becomes necessary to hedge against market
fluctuations. Hedging is done with the help of derivative products that are also known as
hedging products.
Such investment instruments and methods are discussed in this Unit.
Treasury instruments
The Money market is characterized by a number of instruments. The purpose of money
market is to provide short term liquidity to the borrowers and lenders. However, they have
other distinctive features also based on which they are described below.
A. Call Money/ Notice Money

Call money or call deposit is that money that is lent where the borrower has to repay it when
called to do so by the lender. On the other hand notice money refers to that money where the
lender has to give a certain number of days as notice to the borrower to repay the money,
which has been agreed upon at the time of making of the contract.
Key aspects-
1. The tenor of such instruments is 1 to 14 days.
2. The rate at which the funds are lent or borrowed is driven by demand and supply of funds
and prevailing market conditions.
3. Only scheduled commercial banks, co-operative banks and primary dealers are permitted
to operate in call money/ notice money market therefore, it is mostly used by the

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participants for meeting their daily funding mismatches and CRR obligations.
4. Money lent in this market is unsecured therefore, as a prudential measure; each lender
fixes a counterparty limit on each borrower.
5. The regulatory limit on the amount a bank can lend and borrow is also prescribed.
6. The limit is „In a reporting fortnight the average borrowing by a bank cannot exceed
100% of its Tier1+Tier2 capital as at the end of the previous financial year and on any
given day the borrowing should not exceed 125% of the same‟.
7. Similarly „in a reporting fortnight, the average lending by a bank cannot exceed 25% of
its Tier1+Tier2 capital as at the end of the previous financial year and on any given day it
should not exceed 50% of the same‟.
B. Term Money
Term money refers to those lending/ borrowing transactions between the inter-bank
participants which have tenors greater than 14 days. There is no regulatory limit prescribed
for these types of transactions.
C. Gilt Edged Securities (Government Securities)

Government securities are instruments issued by the government to borrow money from the
market for the purpose of raising a public loan or for any other purpose as may be notified by
the Government in the Official Gazette. They are also known as gilts or gilt edged securities.
Depending upon the expiry date, government securities are divided into-
1. Short term government securities are Treasury bills. They have a maturity of less than one
year. There are three main treasury bills in India – 91 day, 182 day and 364 day.
2. Long term government securities are known as government bonds or dated securities.
They have a maturity period of five years, ten years, fifteen years etc.
They may be issued by Central government or state government. Apart from these central
government and state government securities, government agencies or public sector
undertakings issue bonds which are guaranteed by central or state government. Such bonds
are known as Agency Bonds.
Government securities have the following defining features-

1. 1. They have zero income default.
2. 2. There is high rate of return.
3. 3. There is cent per cent liquidity.
4.
They being securities issued by the government, the risk of default is practically non-existent.
In India, the G secs are allocated among the buyers through auction method. This auction
ensures competitive interest rate for government securities. Given their zero risk default
nature, the interest rate is very good for Gsecs. Further the Gsecs are tradable in stock
markets. This means, to get money, the holder can sell it in the stock market. Owing to
collective existence of these three features, government securities are known as „gilt edged

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securities.
D. Treasury Bills
Treasury bills are short term money market instruments issued by the Central Government
through the RBI.
Key aspects-
1. Treasury bills (T Bills) are issued in discounted form, at the end of tenor the holder is
paid a fixed amount called the maturity value. Earlier T bills of four tenors were issued –
14 days, 91 days, 182 days and 364 days.
2. Currently, 14 days T Bills are not being issued.
3. They are issued in denomination of ₹ 25,000 and in multiples thereof.
4. They are issued in the primary market through auction process.
5. The auction calendar is issued by the RBI every year giving amount and dates of auction.
6. Market participants bid for the discounted price and the bids offering least discount are
accepted.
7. Sometimes uniform price auction are also done where cut off price is decided by the RBI
and bidders who bid at a price lower than the cut off price are disqualified and others are
allotted securities at cut off price.
8. T-Bills are accepted as SLR security and are traded in the secondary market. However,
secondary market in T-bills is only moderately active.
9. Clearing and settlement of T-Bills is through DVP method that requires the parties to
submit an SGL note to the Public Debt Office of the RBI. The RBI then makes the entries
in the SGL accounts and current accounts of the parties.
E. Government Bonds
At the beginning of every half of the financial year government brings out a calendar for
issuing dated securities. Closer to the dates specified in the calendar, the RBI announces the
actual details of the security to be issued which include the quantum, the coupon, date of
issue, date of redemption, the dates for payment of interest etc.
Securities are usually issued through an auction process to get market related rates of interest.
The securities being auctioned could be existing or fresh. In the former case it is a price based
auction in which the investors will bid the price at which they are willing to buy the security.
In the later case there is a bid for the coupon rate at which investors are willing to buy the
security.
Securities are also offered on pre-announced coupon rates. If the bids received are more than
the total amount of securities offered for sale, the RBI may make partial allotment to all
applicants.
Apart from above routes, the securities are also sold through „Tap sale‟. In this method no
aggregate amount is indicated in the notification for sale of securities. Sale of securities in
this method may be extended beyond one day or it may be closed at any time or on any day.

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Govt. securities can be issued basically in three forms-

1. Government promissory notes.
2. Stock.
3. Any other form as notified by the Central Govt.
Promissory notes are in the physical form whereas the stock can be either in the physical
form called the Stock Certificate or Book Debt Certificate or in the form of a book entry in
SGL account. For all SGL account holders, all purchases and sales are dealt with in electronic
form through DVP route.
Other players can also enjoy this facility by having one CSGL account with a participant
authorised to open an SGL account in its own name.
The Central Govt. securities are issued in the denomination of ₹ 10,000 and multiples thereof.
The trading takes place in multiples of ₹ 5 crores.
No stamp duty is payable either for primary issue or secondary market transactions.
F. State Government Securities or State Development Loans (SDLs)

The state governments submit to the central govt. their requirement of raising loan on a
yearly basis and the central govt. then notifies it to the RBI which in turn issues these
securities. These issues take place periodically during the year.
For state government securities minimum denomination is ₹ 1,000 and the trading takes place
in multiples of ₹ 1 to 5 crores.
Accounting of SDLs is done through SGL/CSGL accounts
G. Agency Bonds
These are issued by entities usually for raising resources for financing their projects or for
meeting working capital requirement. These securities are generally in the form of bonds or
debentures and are not eligible for SLR purposes hence are also referred to as Non-SLR
securities.
Issuers are-
1. Government owned financial institutions like NHB, NABARD, IDBI.
2. Government owned Public Sector undertakings/units like LIC of India.
3. Private corporates
Issuers are usually highly rated by rating agencies hence are able to access the bond market
for raising funds and at relatively lesser rates of interest. However, the rates offered by them
are usually higher than the rates on Govt. securities due to risk element. Rates of interest

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offered by the corporate are determined by the rating they enjoy and market conditions.
The issue of these bonds is governed by the SEBI (Issue and Listing of Debt Securities)
regulations 2008 and are generally of 5 to 10 years maturity.
These bonds are now issued in demated form and are to be listed on NSE and/or BSE.
They are either taxable or tax free. To issue tax free bonds, specific permission is required for
the issue. The interest earned on tax free bonds is not taxable in the hands of the subscriber
while in the former case it is taxable. Other variants of these bonds like monthly return bonds
or quarterly payment bonds etc. on the basis of payment of interest are also issued by the
corporate.
Agency bonds are usually issued in minimum denomination of ₹ 5,000 and in multiples
thereof.
H. Certificate of Deposit (CD)

Certificate of Deposits are negotiable instruments issued in dematerialized form or as a
usance promissory note, for funds deposited at a bank or other eligible financial institution
for a specified time period.
CDs can be issued by-

1. Scheduled commercial banks excluding RRBs and Local Area Banks.
2. Select all India Financial Institutions that have been permitted by the RBI to raise short
term resources within the umbrella limit fixed by the RBI. Banks have the freedom to
issue CDs depending upon their requirement.
CDs - Key aspects

1. CDs issued by banks are for a minimum period of 7 days and for not more than one year.
Financial Institutions can issue CDs for a period not less than one year and for a period
not exceeding 3 years.
2. CDs can be issued at a discount or at face value. Discount or coupon can be decided by
the issuer.
3. Minimum amount for which a CD can be issued is ₹ 100,000 and higher amounts can be
accepted only in multiples of 1 lakh.
4. CDs attract stamp duty as per Indian Stamp Act.
5. CDs are freely transferable by endorsement and delivery.
6. CDs can be issued to individuals, corporations, companies, trusts, funds, associations etc.
7. Non-resident Indians may also subscribe to CDs but only on non-repatriable basis which
should be clearly stated on the receipt/ certificate.
8. Non-repatriable CDs cannot be endorsed to other NRIs in the secondary market.
9. Loans cannot be granted against security of CDs and they cannot be bought back by the
issuer before maturity.

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I. Commercial Papers (CPs)

Commercial Papers are unsecured instruments issued in the form of promissory notes. CPs
are issued under RBI guidelines.
Corporates can issue CP provided-

1. Its tangible net worth as per the latest audited balance sheet is not less than ₹ 4 Cr.
2. It has been sanctioned a working capital limit by a bank(s) or all India financial
institution(s) and
3. The borrowing accounts of the company are classified as standard asset in the books of
the lender.
The aggregate amount of CP that can be issued by a corporate shall be within the limit
approved by its board of directors or the quantum indicated by a credit rating agency for the
specified rating, whichever is lower. Further, the amount of CP issued should be earmarked
from the working capital limit sanctioned to the company as CP is considered as working
capital finance.
FIs can issue CPs within the overall umbrella limit fixed by the RBI i.e. issue of CP together
with other instruments like CDs/ term money etc. should not exceed 100 percent of its net
owned funds, as per the latest audited balance sheet.
CPs - Key aspects

1. Every issuer shall obtain credit rating for issuance of CP from an approved rating agency.
Minimum rating required for being eligible for issuing CP is P-2 of CRISIL or equivalent
from other rating agencies. Further the rating must be current.
2. CP can be issued for a minimum period of 7 days and maximum up to one year from the
date of issue however, the maturity of the CP should not go beyond the validity date of
the rating.
3. CPs may be issued to and held by individuals, banks, other corporate bodies registered or
incorporated in India, unincorporated bodies, NRIs and FIIs. However, investment by the
FIIs should be within the limit set for their investments in India by SEBI.
4. CPs can be issued either in the form of promissory note or in dematerialized form.
However, presently, banks, PDs and FIs are required to issue and hold CPs only in
dematerialized form.
5. CPs may be issued at a discount or face value as decided by the issuer.
6. Issue of CPs cannot be underwritten or co-accepted.
7. The discount or coupon is decided by the issuer.
8. The instrument is stamped as per Indian Stamp Act.
J. Inter-Bank Participation Certificates (IBPCs)

IBPCs are instruments for borrowing or lending money for short period of time. Here the
borrowing bank sells loans on its books, for a temporary period, to the lending bank. IBPCs

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are of two types, with risk sharing and without risk sharing.
IBPCs - Important Features

1. Only scheduled Commercial Banks can issue IBPCs.
2. The minimum period shall be 91 days and maximum period 180 days in the case of
IBPCs on risk sharing basis. IBPCs in without risk sharing category, total period cannot
exceed 90 days.
3. Participation through IBPCs can be only in standard assets and not exceeding 40% of
outstanding balance or the limit sanctioned whichever is lower. If after issuing IBPC, the
outstanding balance in the loan or cash credit account against which IBPC has been
issued falls then the issuing bank has to pay to the lending bank such amount so that the
IBPC amount is not more than 40% of the balance outstanding in the said account.
4. Inter Bank Participation Certificates (IBPCs) bought by banks, on a risk sharing basis, are
eligible for classification under respective categories of priority sector, provided the
underlying assets are eligible to be categorized under the respective categories of priority
sector and the banks fulfil the Reserve Bank of India guidelines on IBPCs
5. Interest rate is mutually decided between lending and borrowing bank
6. IBPCs are not transferable.
7. They cannot be redeemed before due date.
8. On due date –
a) In case of IBPC without risk sharing basis, the issuing bank shall pay to the lending
bank the amount with interest irrespective of default in the concerned loan
b) In the case of IBPC issued on risk sharing basis also the issuing bank shall pay the
amount with interest. However, if default in the concerned loan account happens then
the issuing bank and the participating bank share the default amount and the
recoveries on mutually agreed terms.
K. Collateralised Borrowing and Lending Obligation (CBLO)

CBLO is a money market instrument developed by Clearing Corporation of India Ltd. It
helps participants who have exhausted their borrowing/ lending limits or are permitted only
limited participation in the market or do not have access to the call money market.
It is a borrowing arrangement against securities placed with CCIL either as margin for
undertaking settlement or otherwise. The securities work as collateral for borrowing.
The process involves-

1. An undertaking by the borrower to repay the borrowed money at a specified future date.
2. An underlying charge on the security held by CCIL.
3. An authority to the lender to receive money lent at a specified future date with an option
to transfer the authority to another person for value received.
Banks, Insurance Companies, Financial Institutions, Primary Dealers, Mutual Funds, NBFCs,
Corporates etc. are members of this segment of the market. They are required to open a

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constituent SGL account with CCIL for depositing securities which are offered as collateral/
margin. An account with the bank designated by CCIL has also to be opened for settlement
purpose. Securities issued by the Central Government only are eligible for acting as margin
or collateral in this market.
Repo and reverse repo

Repurchase Agreements (Repos)/ Reverse Repurchase Agreement (Reverse Repo)
Repo is a transaction in which two parties enter into an agreement where one party agrees to
sell and repurchase the same security. The seller sells specified securities with an agreement
to repurchase the same at a mutually decided future date and at a decided price. Similarly the
buyer purchases securities with an agreement to sell the same to the seller at a mutually
decided future date and at the decided price.
Such transactions, from the seller‟s (acquirer of funds) point of view are referred to as repo
and when viewed from purchasers (supplier of funds) point of view are known as reverse
repo.
They are also referred to as ready forward agreements/ contracts since the security is sold on
spot basis and repurchased on forward basis.
Several securities like G-Secs, PSU bonds, and other securities can be used as underlying
security for repo transactions.
The time between sale and repurchase of securities is known as repo period and the rate of
interest mutually agreed upon is referred to as the repo rate. Repo rate is independent of rate
of interest carried by the underlying security and is dictated by market conditions.
Repos have an advantage over other short term money instrument due to availability of
collateral to the purchaser which pushes down the borrowing rate for the seller. Also, the
purchaser gets securities which qualify for SLR requirement. Therefore, apart from pure
funding reasons, repo transactions are often used to manage short term SLR mismatches.
Repos are also used by the RBI to control liquidity in the market. When there is a need to
decrease liquidity in the market, securities are sold under a Repo arrangement and securities
are bought back through reverse-repo deals to increase liquidity. This is also known as
Liquidity Adjustment Facility (LAF). RBI changes repo rate along with other policy rates
therefore, it is also used as a monetary tool by the RBI.
Repos must be settled through the SGL or CSGL account with CCIL acting as the central
counterparty.

P a g e | 10
Hedging
A hedge is an investment to reduce the risk of adverse price movements in an asset therefore,
making an investment to reduce risk of adverse price movement on the value of an asset is
hedging. Normally, a hedge consists of taking an offsetting position in a related security for
instance to hedge a buy position in foreign exchange a matching sell transaction may be done
so that exchange rate movement on either side will result in minimal or no loss for the bank.
A perfect hedge is one that eliminates all risk in a position or portfolio. However, it does not
happen in reality. Hedging succeeds in substantially reducing the risk and not eliminating the
risk. Besides, it comes with a cost like we take insurance against a potential risk but pay a
premium for buying the insurance. Hedging against investment risk means strategically using
instruments in the market to offset the risk of any adverse price movements. In other words,
investors hedge one investment by making another.
Hedging-Products
Hedging is usually done by using financial instruments known as derivatives.
Derivative is an instrument whose value depends on the value of some other underlying asset
or variable (exposure) which represents a real transaction e.g. a security or exchange rate or
rate of interest or a commodity.
Unlike the underlying, creation of a derivative is not intended to raise finance or trading in
them intended to transfer ownership. Derivatives were rather developed for transferring risk.
Since they allow future price to be set in the present, derivatives make it possible for the
market participants to protect themselves from the risk that market price of the underlying
they hold might change.
Further, unlike in dealing with the underlying exposure, the funds outlay in dealing in
derivatives is much lower as only a small percentage of the transactions have to be paid at the
initial stage as margin. If the derivative is traded on an exchange then depending upon
movement of price, a variation margin may be payable or receivable additionally on a daily
basis. Therefore, for the same outlay of funds a much larger exposure is possible through
derivatives. This feature of derivatives also has in built risk as people tend to take
unnecessary positions.
Commonly used derivatives are-

A. Forward contracts (in foreign exchange).
B. Futures.
C. Options.
D. Swaps.
A. Forward contracts
Forward contracts are contracts to buy or sell the underlying asset on a future date at a price
determined today. It is a hedging tool extensively used in foreign exchange transactions. It is
an arrangement whereby an agreed amount of foreign currency is bought or sold for delivery

P a g e | 11
on a specified future date, at a pre-determined rate of exchange.
To illustrate the manner in which a forward contract works to protect against adverse
exchange rate movement, consider a situation where an importer has to make payment in US
Dollar after six months. The importer cannot be sure of the rate at which he will be able to
buy USD from an authorised dealer after six months. Therefore, he enters into a contract with
an authorised dealer to fix the rate at which the AD will sell USD to him after six months
thereby protecting himself against uncertainty of exchange rate movement over a period of
six months. Essentially the exchange risk has passed from the importer to the AD.
It is possible that exchange rate may move in favour of the importer and he may end up
buying USD at a higher than the prevailing rate at the time of actual transaction but this
possibility he cannot factor in at the time of fixing the cost of his import. Such possibility of a
gain the buyer of the forward contract has to forego to minimise exchange risk.
However, underlying could be any other exposure like stocks.
Forward contracts - Key aspects

1. Forward contracts are OTC (Over the Counter) products i.e. the contract is negotiated
directly between the parties and not through an exchange. Therefore such trades are not
guaranteed by an exchange.
2. Price information of forward contract is not in the public domain.
3. Neither party can unilaterally walk out of the contract. Both are obliged to fulfil their
contractual obligations.
4. If a party wants to reverse its forward position the options available are-
a) Re-negotiate with the counter party to the contract and seek his consent. If he does not
agree then the contract cannot be reversed.
b) Enter into another forward contract for the opposite position with another party.
Forward contracts in foreign exchange are dealt with later in module.
B. Futures
A futures contract is an agreement to buy or sell a standard quantity and quality of a
commodity or financial instrument on a future date through the medium of an exchange
house at a price which is predetermined. By definition futures look similar to forward
contract, but essentially they are different.
The differences are-

Sl No. Forward Contract Futures Contract
1 It is an OTC product It is traded on an exchange.
2. Both the parties have to The contract need not necessarily culminate
necessarily perform their part of into delivery of the underlying instrument. A
the contract futures contract position can be reversed with

P a g e | 12
any member of the exchange.

3 No payment of initial margin is To trade in the futures market, one has to
required become member of the futures exchange by
paying an initial margin and also maintain a
variable margin account with the exchange.
4. The maturity and size of the Maturity and size of the contract are
contract can be customized standardized
5. Settlement only takes place at Settlement is on a daily basis on all the
the time of maturity outstanding contracts – Outstanding positions
at the end of each trading day have to be
marked to market.
6. Counter party risk is high The futures exchange takes care of counter
party risk.
7. Physical delivery of foreign Delivery of futures contracts is minimal.
exchange takes place on the Positions are normally closed out by opposite
maturity date trades.
8. Pricing information is not Pricing information is available in public
available in public domain domain
Futures contracts are available on currencies, bonds, interest rates, stock indices,
commodities etc. and each of these futures contract has its own specifications and procedures.
To understand the working of futures, consider that a bank has a long position (Over bought)
of Euro 1 mio at 1Euro= 0.9450 USD. If Euro weakens against the dollar then there would be
a loss to the bank. To mitigate this risk (hedge) the bank sells 4 Euro futures of 125,000 at the
current futures price of 1 Euro = 0.9500. If Euro falls to USD 0.9400 in the cash market the
loss on the banks long position would be 1 mio * 0.0050 = USD 5000. However, if the
settlement of futures happens at 0.9445, profit on the futures position would be
4*125,000*0.0055 = USD 5500. Therefore on the two transactions put together the bank will
make a profit of USD 500.
However, the Euro/Dollar exchange rate in cash and futures market may not move in tandem,
as in the above case, and the bank may actually make a net loss some times. To mitigate this
kind of risk more off setting positions are taken by the dealers that is why the futures contract
do not generally result in delivery and are closed by taking another position.
C. Options
The difference between Options and futures is that in a „Futures contract‟ both parties are
obliged to the terms of the contract but in option, one party – the option buyer (holder) – has
the right but not the obligation to the terms of the contract i.e. to buy or sell specified quantity
of the underlying asset at a specific (strike) price on or before a specified time (expiry date).
The other party – the option writer – is obliged to the terms of the contract. The underlying
asset may be a commodity like wheat, rice or financial instrument like bonds, stocks etc.

P a g e | 13
The buyer of the option pays a premium (option premium) to the writer of the option for
executing the contract. The price at which the option buyer can exercise his right (called the
strike price) and the date on which the contract would expire (expiry or expiration date) are
mentioned in the contract.
An option to buy is called a Call Option and the option to sell is called a Put Option. Buy or
Sell has to be seen from the point of view of the option buyer and not the option writer.
Example-
Suppose one holds 1,000 shares of X Bank which one wishes to sell some time in the future.
One can exercise an option from A to sell 1000 shares (50 contracts at a lot size of 200 per
contract) of X bank at a price of ₹ 90 per share any time before 31 December 2017.
One can pay a premium of ₹ 9 per share to A for executing the contract.
In this transaction-
1. As an options buyer, one has the right (but not the obligation) to sell 1000 shares of X
Bank to A at the agreed price within the agreed time frame.
2. A is the option writer. He is obliged to buy the shares from you at the agreed price if one
chooses to exercise ones right.
3. 31.12.2017 is the expiration date.
4. ₹ 9 is the option premium which you have paid to A. It is his income irrespective of
whether you exercise the right to sell the shares or not.
5. ₹ 90 per share is the exercise price.
If the price of X Bank shares in the market falls below ₹ 90 to say ₹ 80 then one can exercise
ones right to sell and A will be obliged to buy shares at ₹ 90 per share. In this transaction A
would incur a net loss of ₹ 1 per share (₹ 10 price differential – ₹ 9 option premium). One has
protected oneself against market price fall but incurred cost of premium.
If however, the market price of the share goes to say ₹ 110 then one will not exercise ones
right to sell at ₹ 90. The shares can be sold in the market at the rate of ₹ 110 per share.
Therefore the option can be allowed to lapse. „A‟ would have earned the premium and the
other party would be the net gainer by selling in the market at a price higher than the strike
price after netting premium.
Indian regulations permit options up to 12 months maturity. SEBI however, permits options
for up to 3 years on the Nifty and Sensex.
D. Swaps
A swap in simple terms can be explained as a transaction to exchange one thing for the other
or „barter‟. In the financial market the two parties to a swap transaction contract to exchange
financial instruments. These instruments can be almost anything, but most swaps involve
cash flows.

P a g e | 14
In currency swaps, cash flow in one currency is exchanged for cash flow in another currency.
However, in currency swaps not only interest payments but also principal amounts are
exchanged both at the time of entering into the contract and also at the time of termination of
the contract.
Forward Rate Agreement (FRA)

A Forward Rate Agreement, or FRA, is an agreement (financial contract) between two parties
who want to protect themselves against future movements in interest rates. By entering into
an FRA, the parties lock in an interest rate for a stated period of time starting on a future
settlement date, based on a specified notional principal amount.
Accordingly, on the settlement date, cash payments based on the contract are made by the
parties to one another. Payments are based on a benchmark floating rate like LIBOR/
MIBOR.
Generally buyer of FRA looks for protection against rise in interest rates while seller of FRA
looks for protection against fall in interest rates. For instance, in India, most corporate have to
pay bench marked linked floating rate of interest on their borrowings. In rising interest rate
scenario, the corporate run the risk of the benchmark rate going up resulting in rise in their
interest payment outgo. By buying FRAs the corporate is able to convert the floating rate of
interest on his borrowing into a fixed rate liability thus insulating himself against the risk of
rise in benchmark rate.
In fact therefore, an FRA is a simple forward contract on interest rate where the performance
is limited to payment of interest differential on a given notional principal amount. It also is an
OTC product like forward contract hence size and periods can be customised to suit the needs
of the customer. Since the commitment is restricted to settlement of interest differential,
counterparty or credit risk in FRAs is minimal.
Domestic and Forex Treasury

The treasury department in a bank plays a dual role, it provides an interface between the
bank and the external market on one hand, and between the asset and liability of the bank‟s
balance sheet on the other hand. Thus, it provides a balance between the two, which
enables a bank to maximise its return on the assets without in any ways compromising on
the liquidity part of the balance sheet. Treasury of a bank can be domestic as well as forex
treasury. Domestic Treasury should provide for a balanced and well diversified liability
base to fund the various assets available in the balance sheet.
Aspects related to domestic and forex treasury is dealt with later in the module.
Money market instruments have evolved over a period of time to suit short term liquidity

P a g e | 15
requirement of the market participants. Those having surplus can lend to earn some income
and those in need of liquidity can borrow at market determined rates to fulfil their
requirements. The controllers also use these instruments to control liquidity in the market and
also for meeting funds requirement of the central and state governments.
Since these instruments are tradable in the market, they are vulnerable to market risk hence
different financial instruments have been developed to mitigate market risk inherent to the
money market instruments.
Unit summary
 Overview of treasury instruments - Treasury bills, bonds, CDs, CPs, Repo and reverse
repo, gilt edged securities, Hedging products.
 Domestic and Forex Treasury.


(Banking & Finance)

and Market Risk
Management
Unit 4
Page |1
Introduction
learner requirement and from learner’s perspective.
“NEIPL”.

Page |2
Unit 4
 Introduction to Foreign Exchange.
 Exchange Market.
 Statutory Basis of Foreign Exchange.
 Outline of Exchange Rates and Types.
 Introduction to FEMA.
 Administration of Foreign Exchange Transactions.
Introduction to Foreign exchange

Foreign Exchange relates to any monetary transaction involving citizens belonging to two
different set of countries. Foreign exchange transactions can be broadly classified into
Trade related transactions i.e. Import and Export of goods and services and/or non-trade
related transactions i.e. going abroad on tour, medical treatment which is more of a
personal nature or involvement of an individual for personal needs. In simple terms, any
economic activity that takes place between residents of two countries and involves the
exchange of one currency into another is known as Foreign exchange. A resident of one
country who may import goods or services from another country or exportgoods or
services to another country requires foreign exchange to make payment in the currency of
the other country or any other currency acceptable to the seller of goods or provider of
service.
In simple terms, Foreign Exchange can be defined as “conversion of currencies from the
currency of invoice to the home currency of the exporter or the currency he desires to
receive payment in”.
Each currency has its own jurisdiction to function as legal tender for settlement of debts.
Beyond the country of issue, the currency cannot function as legal tender, and requires
mediation of Banks and the power to convert. When transactions are routed through Banks,
the banks can convert one currency to another as per the prevailing law in the country. This
process of conversion of home currency into foreign currency is known as Foreign
Exchange transactions.
Thus a foreign exchange transaction is a contract to exchange funds in one currency for
funds in another currency at a mutually agreed rate. Exchange rate means the price at
which the currency of transaction will be exchanged or converted into home currency. The
exchange rate is a very dynamic and volatile rate. The rate is determined based on the
market forces, mainly by demand and supply, therefore it changes at every second, minute
and hour.

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Exchange market
The market where the transactions of converting one currency into another takes place is
called the Exchange Market. The transactions involving conversion of one currency into
another essentially mean that one currency is bought and the other is sold. Therefore,
Exchange Market refers to the market where currencies are bought and sold like a
commodity. It is to be distinguished from Financial Market where currencies are borrowed
and lent.
Salient Features of Foreign Exchange Market

1. Size: It is the largest financial market in the world. As per BIS survey, in 2010, average
daily turnover in this market was 4 trillion dollars.
2. Location: The Foreign Exchange market is not a physical place where all Dealers
assemble at an appointed time and trade. Foreign exchange market, world over, execute
their jobs sitting in their respective offices through electronic communication apparatus
i.e. Hot-Lines between the Banks and the Brokers. In short, the Foreign Exchange
market is entirely dependent on technology and therefore it is a communication system
based market, with no physical boundaries.
3. 24-Hour Market: Forex markets are dynamic markets and operate round the clock
within a country or between countries. For e.g. when it is a day in India, it is night in
USA. When it is afternoon in India, it is morning in London. Hence while people sleep
the trade is not sleeping but goes on 24 hours a day at one or the other centre.
4. Five Day Operations: Forex markets usually operate from Monday to Friday world-
over except in the Middle East, which observes holiday on Fridays. The world markets
are closed on Saturdays and Sundays.
5. Participants: It comprises of a vast number of market participants which includes

individuals, business entities, commercial and investment banks, central banks, cross
border investors, arbitrageurs and speculators across the globe who buy and sell foreign
currency, just like any other commodity.
6. Currencies Traded: US Dollar is the most dominant currency of the world and a vast
majority of transactions are denominated in USD.USD is involved as one of the
currency in roughly 85% of foreign exchange transactions followed by Euro (39%),
Japanese Yen (19%) and GBP (9%). Most traded pair of currencies is USD/Euro
(28%), USD/JPY (14%) and USD/GBP (9%).
7. An OTC Market: The participants in the market deal with each other directly without
intervention of any exchange house or clearing house.
8. Volatility: Foreign exchange rates change very fast -almost every four seconds.

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9. ADs as Market Makers: The foreign exchange market is a dealer market and all
participating dealers are market makers. Hence, any dealer who would like to buy or
sell the foreign currency will call the other dealer and seek a quote. The dealer from
whom the quote is sought has to mandatorily give a two way quote which is known as
bid and offer quote. The bid price represents quoting dealer’s price for buying and offer
price represents the selling price. For example a dealer quoting USD rate against Indian
Rupee quotes 66.65/67, it means that he is willing to buy one USD for ₹ 66.65 and sell
for ₹ 65.67.
10. The dealer receiving the quote takes a decision in a fraction of a second after studying
the trend which is readily available on his Reuters screen. After making a careful study
of the market the Dealer takes a decision to confirm or to not confirm the deal and he
approaches the Dealer who gave him the quote. The dealer who quoted should agree to
the deal specifically and then only the deal stands confirmed. It is to be noted that only
the rates confirmed over the telephone or through the system are final because quotes
are given by every dealer for the asking and until it is quoted and confirmed as final by
the Dealers either orally or through established communication systems.
11. Indian Scene: In India, the exchange rates are uploaded on FBIL (Financial
Benchmarks of India Ltd) website in the morning. All Authorised dealers use such
rates as the base rate and load their charges and upload it on their site viz., Reuters,
Bloomberg etc. The sites are updated on an ongoing basis and any subscriber can
access these pages for business purposes.
The currency market is spread over the world with a large number of participants from
every nook and corner of the world. In India there are restrictions imposed by Government
of India through the RBI for taking INR out of the country. In India full convertibility is
still not introduced as far as business of foreign exchange is concerned. It may be noted
that though full convertibility is not introduced in India, the Government of India through
the RBI has partially opened up the economy and the Indian citizens can now acquire forex
up to the extent of USD 2.50 lakh for remittance purposes including for travel, trading,
investments, hedging and speculative purposes. The partial opening of the economy has
added to the volumes of the forex markets.
Reserve Bank of India, being a bankers’ bank is an interested party who would not only
like to develop the foreign exchange business of the banks on behalf of the country but
would like to see that the business in done in an orderly manner. The RBI has also directed
banks to follow the norms given below in their day to day dealings and they are:
1. Maintain a near Zero position i.e. NIL position at the end of the day.
2. Find reasonably matching maturities for transactions entered into the position.
3. Always keep need based balance in the Nostro account and to dispose of excess
balance.

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4. Deal with Indian interbank exchange market and if need be only approach international
market for their cover operations.
5. Monitor flow of money in the Non-resident rupee account particularly for funding and
repatriation, so as to keep a tab on hot money and also on speculative transactions,
which may destabilise the economy. Global market – No barriers.
In addition to the RBI guidelines on the Exchange market there are statutory requirements
as well.
Statutory basis of Foreign exchange

Every Country needs foreign exchange to import goods and services including technology
which are not available in their country and are of vital importance for Nation building. It
should be borne in mind that every country will try to save foreign currency by restricting
its imports and encouraging exports and therefore there is always a scarcity of foreign
currency.
After independence India required foreign exchange and India had to build the required
reserve to meet its demand for imports. In order to conserve foreign exchange, the British
had introduced the Defence of India Rule popularly known as DIR. After independence in
1947, the Indian Government replaced the DIR Act by a more draconian Act popularly
known as Foreign Exchange Regulation Act of 1947 or FERA, there-by enabling the
Government of India to conserve foreign exchange by restricting the outflow of foreign
exchange for investments, business, imports and remittances. It may be noted that violators
of the FERA were arrested under COFEPOSA (Conservation of Foreign Exchange and
Prevention of Smuggling Activities).
Exchange control means officially restricting the outflow and monitoring the inflow of
foreign exchange, covering a large area of operations i.e. imports, exports, services,
remittances, inflow and outflow of capital, rate of exchange, methods of payment, opening
and maintenance of balances in accounts abroad, acquisition and holding of foreign
securities, financial transactions between a resident and an NRI.
In other words, exchange control means, rationing of foreign exchange for various
purposes based on the earnings and spending. The monitoring on earning of foreign
exchange and surrendering the same to a common authority i.e. in India, to RBI was
mainly to have a centralised control over the foreign currency earned to enable the
Government of India to make use of it judiciously for the purpose of Nation’s urgent
requirements like arms and ammunition to defend the country, food stuffs to feed the
population and such other commodity which are required for the general interest of the
nation. In simple language, rationing was introduced just to restrict the demand and restrain
the citizen from demanding release of foreign exchange for non-productive purpose
broadly keeping in mind the national interests and to remain within the limits of available

Page |6
resources.
In short, the intention of the Government of India was to control outflow of foreign
exchange so as to maintain the value of the Indian currency in the international markets in
terms of currencies of other countries and also to maintain Indian’s balance of payment
position.
Control was implemented by the Government in the following ways-

1. Control of the exchange rate i.e. the rate of conversion of foreign exchange was
decided by the RBI.
2. Methods of payment were introduced i.e. fixing the currencies in which payment of
imports and exports will be made and received. This was done to conserve precious
foreign exchange which was very scarce. For e.g. any imports made from say Russia
the payment will be done in Indian Rupees only for which a bilateral arrangement with
Russia was entered into. Similarly any payment to be made to say Pakistan, will be
done in rupees through the ACU mechanism (Asian Clearing Union – a mechanism to
facilitate payment and settlement of eligible transactions among member countries on a
multilateral basis so as not to depend upon the use of their foreign exchange reserves
which are in hard currency).
3. Bilateral agreements i.e. trade agreements entered into between two countries to avoid
balance of payment problem for both the countries.
The policy of Control of Exchange was determined by the Ministry of Commerce and was
administered through the Export Import Policy. The control on foreign exchange was
regulated through the act i.e. FERA 1947 and 1973.Day to day administration was carried
out by the Reserve Bank of India through their Exchange Control Department.
The import-export policy used to lay down the exchange control policy based on which
every person, firm, company or authority in India earning/ receiving foreign exchange
expressed in any currency other than currency of Nepal and Bhutan was required to
surrender the foreign exchange so earned to the authorised dealer within a specified time
from the date of acquisition of the foreign exchange. Violators were imposed with stiff
penalties including jail terms under COFEPOSA.
The Reserve Bank of India had also made it obligatory on part of any person in India
acquiring foreign exchange abroad by way of services rendered, assets held, inherited,
settlement, gift, remuneration to bring the same into the country and, within specified
period, surrenderit to an authorised dealer in India to get it converted into Indian rupees on
thesame day’sprevailing rate of exchange.
Similarly, any person in India wanting to import goods or services into India was required
to obtain an import licence from the authority concerned (at that time JCCI and now
DGFT) and make the payment as per the export import policy in force. Persons intending

Page |7
to remit foreign currency abroad for medical treatment, gift, purchase of books, studies
abroad, were required to make an application to the Reserve Bank of India through an
authorised dealer and obtain specific permission.
The conversion rate of foreign currencies was controlled by the RBI. The rate of
conversion of foreign currencies was determined by FEDAI based on the rate announced
by RBI every working day (Monday to Friday) and was flashed on the Reuters screen to
enable authorised dealers in Foreign exchange to load their margins and apply the same to
the customers while undertaking the foreign exchange transactions.
In 1999, after the foreign exchange reserve position of the country improved significantly,
the foreign exchange regime was relaxed to a great extent by replacing FERA by
FEMA(Foreign Exchange Management Act).With introduction of FEMA the focus shifted
from prescribing what can be done to permitting all transactions except listing some
transactions that cannot be done or can be done with permissions from specific authorities.
Details of FEMA is dealt with later in this unit.
To enable the public to put through a transaction in foreign currency, the RBI has
authorised banks, travel agents, money changers and such other authorised persons to
undertake foreign exchange related transactions. Other than such authorised persons, no
person in India is allowed to undertake foreign currency transactions.
Outline of exchange rates and types

Foreign Exchange transactions involve conversion of one currency (for e.g. Indian Rupee)
into another (for e.g. USD) and for that purpose, the exchange rate is required for
calculations. In other words the value per unit of one currency in terms of another currency
is called the rate of exchange.
Foreign Currency is like a commodity. The Indian rupee is not a legal tender outside India.
Similarly, the US dollar cannot be used for settlement of any debt in India, but at the same
time, it has value and therefore it is considered as a commodity in foreign exchange
dealings.
In the case of product/goods, people need to purchase goods from manufacturers and sell in
the domestic market. However, in the case of Foreign Exchange, the Bank as an
Authorised dealer, purchases as well as sells foreign currency. In foreign exchange
dealings therefore, though the commodity is one i.e. the currency, there are always two
types of transactions i.e. Purchase and Sale in each transaction.
Therefore, in banking parlance, in foreign exchange dealings, the word “purchase”, means
bank has purchased foreign currency and the word “sale”, means the bank has sold foreign
currency. In other words, in purchase transactions the bank acquires the foreign currency

Page |8
and in return gives away home currency i.e. Indian rupee in our case and in a sale
transaction, the bank parts with foreign currency and receives the home currency, in our
case Indian Rupee .
While dealing in foreign exchange transactions there are two important aspects to be
considered-
1. Foreign exchange transactions should always be viewed from the bank’s point of view.
2. The item referred to is a commodity i.e. foreign currency (Here foreign currency is to
be considered as a commodity and not money).
Factors that Influence Exchange Rate

Foreign exchange rates get influenced mainly by demand and supply of currency in
question Demand and supply in turn gets influenced by several factors/events. Some such
important factors are as follows-
1. Monetary Policy: The monetary policy of the country should be tight because of which
the ROI is high which cools down the economy and therefore drives down the inflation,
which diverts funds in the currency markets. Even fall in bond yields also supports the
currency.
2. The government’s financial policy: The government’s tight fiscal policy encourages the
market, but a lax policy weakens the currency.
3. Inflation: If inflation is high, then it weakens the currency whereas if the inflation is
low, it strengthens the currency.
4. Balance of payment: If there is a trade surplus, it strengthens the currency, and if not it
weakens.
5. Investment Climate: A stable government and its policies, sound economic
fundamentals, policy to attract foreign investment i.e. FDI – All these factors contribute
to the strengthening of the currency.
6. Foreign Exchange Reserves: A robust reserve position becomes a plus point for a
country to ward off speculative attacks on the currency.
7. Foreign Debt: Ratio of forex debt matters because high forex debt is considered
adverse.
8. Self-sufficiency in Food Stocks: If the food stock position is comfortable, then threat to
high inflation is low, hence low risk is favourable to currency.
9. Commodity Prices: For an Agri and commodity based exporting country if the Agri
produce and commodity price is high then it favours the exchange rate of major
producers of these products.
10. Growth of Domestic Products: If the GDPis growing well then it favours currency.
11. Political Stability: Political stability of the country speaks well for the currency.
Types of exchange rate

There are two types of exchange rates-
1. One is direct quotation that is exchange rate is quoted in home currency (₹ 63.01 for
one USD).

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2. One is indirect quotation that is exchange rate is quoted in foreign currency (USD 1.40
for ₹ 100).
In India, till 1966, direct quotation was in vogue. However, after devaluation of the Indian
rupee, indirect quotation became the main stay. Subsequently to establish transparency,
effective from August 02, 1993, again in India, direct quotation method was adopted and
the same continues. In direct quotation, the slogan adopted is “Buy Low”, “Sell High”
whereas in Indirect quotation it is “Buy High”, “Sell Low”.
In foreign exchange banking, the quotation between banks will have two rates i.e. one at
which the quoting bank is willing to buy and the other at which it is willing to sell foreign
currency. In other words quotation of rates for interbank foreign exchange transactions is
two way.
Different types of rates and transactions are-

1. Spot and Forward transactions: In forex dealings the delivery of the currency may be
on the same day, two days later or sometime after a month of the deal. If the deal to
buy and sell is agreed upon and executed on the same date i.e. the day of the
transaction it is known as cash transaction or value today transaction. The meaning of
value date has a lot of relevance in foreign exchange dealings. Value date means the
day on which the respective currency should be credited to the account of the
respective banks i.e. Suppose Bank A in India make a deal of selling USD 1 Mio to
Bank B in India value today than today the foreign currency should be credited to the
Nostro account of Bank B. In the same way Bank B is required to credit the equivalent
Indian rupees in the specified account of Bank A on the same day.
2. Two days later: If the transaction is required to be settled after two days of the deal, it
is known as Spot transaction. Suppose in the above example Bank A sells USD I Mio
to Bank B on Monday, value spot then Bank A should see to it that the foreign currency
is credited to the Nostro account of Bank B on Wednesday. The Forex market operates
world over and the operating time in different zones is different. Hence deals concluded
are mostly on spot basis.
3. Some days later say after a month: In this type of transaction, the delivery takes place
after one month. Such transactions are known as Forward transaction.
4. Forward rate and Spot rate: When the forward rate and the spot rate are the same
than it is said to be at par with spot rate. But such a situation happens very rarely. It is
found that more often the forward rate may be higher or lower than the spot rate. This
difference in the rate is known as forward margin or swap points. The forward margin
could be at a discount or may be at a premium. If the forward margin is at a premium,
than the foreign currency will be costlier under the forward rate than under the spot
rate. If it is otherwise that is if the forward margin is at discount, the foreign currency

P a g e | 10
will be cheaper for forward delivery than for spot delivery. It has to be borne in mind
that to arrive at a forward rate, premium is added and discount is deducted in both type
of transactions i.e. sale or purchase.
It may also be noted that if the currency is at a premium in the forward market, the
forward margin is quoted in ascending order and if it is at a discount then the forward
margin is quoted in descending order. For instance, if the forward margin for a
currency is quoted as 45/50 then the currency will be at a premium in the forward
market and if the forward margin is quoted as 50/45, it indicates that the currency will
be at a discount in the forward market.
Therefore, Forward Rate = Spot rate + premium or Spot rate – discount, as the case
may be.
If the value of the currency in the forward market is more than what is being quoted in
the spot market, then it is said to be at a premium, while if the currency is cheaper at a
later date than spot rate, then it is called at a discount.
5. The following will give an idea about the premium and discount rates: Assume that
USD is quoted at ₹ 67.50/25 in the spot market i.e. one USD is being bought at ₹.67.50
and sold at ₹67.25. Now if the six month forward margin being quoted is say 45/50
paisa, it means that the USD is being quoted at premium in forward i.e. the forward rate
will be ₹ 67.95/67.75. Here the USD is at a premium, while the Indian rupee is at a
discount, that is USD is dearer for future value and Indian rupee is cheaper for future
value.
Similarly, if the forward margin in the above example is quoted as 50/45, it would
suggest that the forward rate for USD is at a discount hence the forward margin should
be deducted from the spot rates at arrive at forward rates. In this case the forward rate
will be ₹ 67/66.80
6. Direct and Indirect Quotes: In India, earlier the rate quoted was indirect i.e. USD
1.20 for every ₹ 100. Now in India direct rates are quoted i.e. ₹ 63.01 for one USD.
From the above you will observe under direct quotes, the local currency is variable and
on the other hand under indirect method, the local currency remains fixed i.e. ₹ 100.It
would not be out of place to say that most of the trade world over is done in USD. It is
a global practice that rate for USD is quoted by using direct method that is one USD =
so many units of local currency.
Only in case of GBP, Euro, AUD, and NZD in-direct rates are quoted. For e.g.:
GBP/USD – USD 1.6000/10 per GBP.
7. Cross Rates: When a rate for a particular currency pair are not directly available, the

P a g e | 11
price for the said currency pair is then obtained indirectly, which can be explained as
follows:-
a) For example you need a quote for GBP/INR and nobody in the market gives a
quote for such a pair in that case, you can take a quote for GBP/USD and
USD/Rupee and arrive at GBP/INR rate.
Assume that for one USD you need to spend ₹ 67.50 and if you spend USD 1.60 to
get one GBP. So to get one GBP you need to spend ₹ 108 i.e. USD 1.60 X ₹ 67.50
= ₹ 108.
Types of Foreign Exchange Buying and Selling Rates

Besides the above rates, there are other rates that are quoted/applied for various foreign
exchange transactions e.g. exporter/importer and remittances. These rates are also
furnished to the foreign exchange designated branches by the treasury and are known as
card rates.
1. TT Buying Rate: This rate is applied where funds are already credited to our Nostro
account i.e.an NRI has remitted foreign currency which has been credited to the Nostro
account of the bank and rupee equivalent is now required to be credited to his NRE
account. Normally this rate is a better rate than Bills Buying rate because here the
foreign currency is already received in advance and we are required to part with Indian
rupees at a later date.
2. TT Selling Rate: This rate is applied where foreign currency is required to be sent
abroad after Indian Rupee equivalent has been received by the bank. We have received
the Indian rupee equivalent and now we are required to convert the Indian rupee into
foreign currency and remit the money. In this case also we receive the rupee funds in
advance and our account in foreign currency will be debited at a later stage. For e.g.
student studying abroad – his hostel fees is required to be remitted.
3. Bills Buying Rate: Whenever an export takes place, the relevant export documents are
required to be submitted to any authorised dealer within 21 days from the date of the
shipment. As and when a document is submitted to an authorised dealer and if the
exporter wishes to avail financial assistance, at that time for the purpose of conversion
of the bill amount, the Bill Buying rate is applied. This rate is slightly lower than the
TT Buying rate because it takes time for the foreign currency to be realised and
credited to our Nostro account.
4. Bills Selling Rate: This rate is applied to the transactions which involve handling of
bills of exchange/ other documents by the AD for selling foreign currency e.g. when an
AD receives bills for making payment for an import, bills selling rate will be applied
for converting INR received from importer into FC.
5. TC Buying Rate: This rate is applied to all such tourists and other persons tendering
traveller’s cheque for encashment.
6. TC Selling Rate: Whenever a tourist or a businessman visits abroad he requires
traveller’s cheques to meet his expenses abroad. While issuing travellers cheques the
banks apply TC selling rate.
7. Currency Buying Rate: This rate is applicable for all such tourists and other persons

P a g e | 12
tendering hard cash for purchase.

8. Currency Selling Rate: This rate is applicable for all such persons who go abroad on
tourist visa or other visas and need hard cash to spend in the foreign country.
FEMA
Foreign Exchange Management Act (FEMA) 1999
The FEMA of 1999, was enacted by the statute of Parliament but was implemented from
01.06.2000 by replacing FERA of 1973. The FEMA 1999 was enacted keeping in mind the
changed environment not only in the country but the world over. The Act was brought in,
mainly to facilitate international trade as also to bring in discipline in the maintenance and
development of foreign exchange markets in India to take it to the international level.
The amended act provides complete clarity in the definition of doing international business
and removal of ambiguity that existed in the previous act i.e. the FERA of 1973.
It also marks introduction of Management of Foreign Exchange market in the country in

place of Regulation of Foreign Exchange market. However, it does not mean that the
regulation has been completely done away with. Regulation of the FX market still remains
but with a considerable degree of freedom for doing transactions without making reference
to the RBI.
Some of the important features of FEMA 1999 are-

1. Non-compliance of any regulations will be considered as civil offence and not a
criminal offence as was the case in FERA regime.
2. What constitutes current account transactions and what constitutes capital account
transactions are clearly spelt out.
3. The definition of a resident and a non-resident with reference to their stay in India is
now in tune with Income tax act. Earlier, definition of NRI was at variance with
definition of NRI as per the Income Tax Act.
4. The new act is positive in the sense that all current account transactions not otherwise
restricted can be freely carried out.
The provisions of FEMA empowers the RBI to issue guidelines, call for reports/data, and
impose penalties for violations of any provisions therein and also for not complying with
its direction.
The provisions relate mainly to-

1. Foreign travel.
2. Remittances include Gift, Donations, Subscription to magazines, Periodicals,
Consultancy services, Payment under Cards.
3. Investments abroad.
4. Foreign Currency Accounts in India (FCA).

P a g e | 13
5. Exchange Earner’s Foreign Currency Account (EEFC).

6. Resident Foreign Currency (RFC) Accounts.
7. Resident Foreign Currency (Domestic) (RFCD) Accounts.
8. Diamond Dollar Account (DDA).
Administration of Foreign Exchange Transactions

The roles and responsibilities for administration of foreign exchange transactions in our
country are as follows.
Government of India
The Central Government is empowered by FEMA to notify rules for carrying out the
provisions of this Act.The Act also authorises the Central Govt. to issue directions to RBI
and the latter is bound to comply with the same.
Reserve Bank of India

The Act authorises RBI to administer foreign exchange transactions under the guidance of
Govt. of India. It has powers to make regulations on any matter relating to foreign
exchange transactions.
The Act authorises RBI to appoint Authorised Persons (APs) to deal in foreign exchange. It
has powers to issue directives to the Authorised Persons and they are bound to comply with
such directives. RBI can inspect the books of APs and penalise them in case of non-
compliance of the directives.
RBI gives directives of general nature by issuing AP (Dir) series circulars while specific
directives are given by way of letters to APs.
Authorised Persons
Any entity (company/ firm/ individual) appointed by RBI to deal (i.e. buy and sell) in
foreign exchange is called an Authorised Person (AP). Depending up on the powers/
authority delegated by RBI to them, the APs are classified into the following four
categories.
Authorised Dealers Category I: They are permitted to perform a wide range of foreign
exchange transactions including holding foreign currency/foreign exchange without any
limit. In short, they can do all current and capital account transactions as delegated to them
by the RBI. Generally scheduled banks are appointed as AD Category I.
Authorised Dealers Category II: They are permitted to only release foreign exchange for
non-trade remittances i.e. private visits, business travel, medical treatment abroad, overseas
education, Visa fees etc. In other words they are permitted to do only a limited type of
foreign exchange transactions. Such licences are given to financially strong RRBs, Co-
Operative Banks and Full Fledged Money Changers who are considered fit for

P a g e | 14
upgradation.
Authorised Dealers Category III: Certain financial and other institutions like NABARD,
IFCI which are required to do foreign exchange transactions incidental to their activity are
permitted to do foreign exchange transactions to meet their own requirements but not for
public at large. Such ADs are called Authorised Dealers Category III.
Full Fledged Money Changers: Money changers do the exclusive activity of changing
foreign currency into home currency or changing home currency into foreign currency. The
RBI appoints certain organizations as FFMCs to provide additional avenues to the public
for encashment or issue of foreign currency and travellers cheques even at the hotels and
airports. Thomas Cook (I) Ltd., Trade Wings Ltd. are FFMCs.
Different Categories of Branches of an Authorised Dealer

All branches of a Bank (AD) are not permitted to handle foreign exchange transactions.
The branches which are not permitted to transact foreign exchange transactions are
categorised as Category C branches by RBI. These branches have to do foreign exchange
transactions, if the need be, through a designated branch. The branches which are permitted
to do foreign exchange transactions are called designated branches. The designated
branches are further categorised as follows.
Category A
Branches/ Divisions of a bank which are not only permitted to handle all types of foreign
exchange transactions but also maintain and operate bank’s Nostro accounts are called
category A designated branches.
Category B
Branches permitted to do all types of foreign exchange transactions which the bank is
permitted to do, but not maintaining Nostro accounts are called Category B branches. They
can however, operate bank`s Nostro accounts.
Unit summary
 Introduction to Foreign Exchange.
 Exchange Market.
 Statutory Basis of Foreign Exchange.
 Outline of Exchange Rates and Types.
 Introduction to FEMA.
 Administration of Foreign Exchange Transactions.


(Banking & Finance)

and Market Risk
Management
Unit 5
Page |1
Introduction
“NEIPL”.

Page |2
Unit 5
 Inward and outward remittance in foreign exchange - procedural aspects.
 Foreign Exchange Management (Current Account Transactions) 2000.
 Liberalized Remittance Scheme.
 Exchange houses and drawing arrangements.
 Canara Bank branded remittances.
Introduction
In India since 1935, there is control on outflow of foreign currency. After independence in
1947, the Government of India enacted the Foreign Exchange Regulation Act [FERA]
1947, to control in-flow and out-flow of foreign currency. Subsequently in the year 1973
certain amendments were carried out and the act came to be known as FERA 1973.
After globalisation and liberalisation, the FERA Act of 1973 was replaced with the Foreign
Exchange Management Act [FEMA] 1999.
In order to make the rupee partially convertible and let the market forces determine the
exchange rate, remittances under current account transactions were freed to a large extent
under FEMA 1999. The relaxations given under FEMA also extended to foreign exchange
remittances. Resident Indians are now free to remit foreign exchange up to liberalised
limit, for various purposes without reference to RBI.
Inward and outward remittances in foreign exchange for residents under the Foreign
exchange management (Current Account Transactions) 2000 and under the Liberalised
Remittance Scheme are discussed in this unit. Key aspects with respect to remittances for
NRIs and PIOs are also discussed in this unit.
Remittances in foreign exchange

Liberalisation in remittance of foreign currency is an exercise which is undertaken by the
Government of India, through RBI on an ongoing basis.
To begin with the process of liberalisation and globalisation, the GOI in consultation with
RBI, has permitted release of foreign exchange to persons resident in India for various
current account transactions, the details of which are enumerated hereunder-
1. Private visits.
2. Remittance by tour operators/ travel agents to overseas agents/ principals/ hotels.
3. Business travel.
4. Fee for participation in global conferences and specialized training.
5. Remittance for participation in international events/ competitions (towards training,

Page |3
sponsorship and prize money).

6. Film shooting.
7. Medical treatment abroad.
8. Disbursement of crew wages.
9. Overseas education.
10. Remittance under educational tie up arrangements with universities abroad.
11. Remittance towards fees for examinations held in India and abroad and additional score
sheets for GRE, TOEFL, etc.
12. Employment and processing, assessment fees for overseas job applications.
13. Emigration and emigration consultancy fees, skills/ credential assessment fees for
intending migrants.
14. Visa fees.
15. Processing fees for registration of documents as required by the Portuguese/ other
Governments.
16. Registration/ subscription/ membership fees to International Organisations.
In respect of the liberalized regime of releasing foreign exchange for above purposes, the
following guidelines may however, be noted-
1. Usage of International Credit Cards (ICC), International Debit Cards (IDC), ATM
cards abroad etc. would be treated as part of the foreign exchange released.
2. Release of foreign exchange is not admissible for travel to and transaction with
residents of Nepal and Bhutan.
3. Though the release of foreign exchange for travel purposes has been made easy, the
traveler-
a) Is now required to submit a declaration regarding the amount of foreign exchange
availed of during the financial year since the ceiling has been fixed for remittance
for travel purposes for the whole year.
b) In case of issue of traveler‟s cheques, the traveler should sign the cheques in the
presence of an authorised official and the purchaser‟s acknowledgement for receipt
of the travelers cheques should be held on record.
4. Out of the overall foreign exchange being sold to a traveler, exchange in the form of
foreign currency notes and coins may be sold up to the limit indicated below:
a) Travelers proceeding to countries other than Iraq, Libya, Islamic Republic of Iran,
Russian Federation and other Republics of Commonwealth of Independent States -
not exceeding USD 3000 or its equivalent.
b) Travelers proceeding to Iraq or Libya - not exceeding USD 5000 or its equivalent
c) Travelers proceeding to Islamic Republic of Iran, Russian Federation and other
Republics of Commonwealth of Independent States - full exchange may be
released.
d) Travelers proceeding for Haj/ Umrah pilgrimage- full amount of Basic Travelers

Page |4
Quota [BTQ] entitlement in cash or up to the cash limit as specified by the Haj
Committee of India, may be released.
5. Medical Treatment
a) With a view to enable residents to avail of foreign exchange for medical treatment
abroad without any hassles and any loss of time, release of foreign exchange up to
an amount of USD 100,000 or its equivalent, on the basis of self-declaration that
the applicant is buying exchange for medical treatment outside India, without
insisting on any estimate from a hospital/ doctor is permitted.
b) For amount exceeding the above limit, estimate from the doctor in India or hospital/
doctor abroad, is required to be submitted to the A.D.s.
c) A person who has fallen sick after proceeding abroad may also be released foreign
exchange by an A.D. for medical treatment outside India.
6. Cultural Tours
a) Dance troupes, artistes, etc., who wish to undertake tours abroad for cultural
purposes should apply to the Ministry of Human Resources Development
(Department of Education and Culture), Government of India, for their foreign
exchange requirements.
b) A.D.s may release foreign exchange, on the strength of the sanction from the
Ministry concerned, to the extent and subject to conditions indicated therein.
7. Private Visits
Foreign exchange for private visit can also be released to a person who is availing of
foreign exchange for travel outside India for any purpose up to the limits specified.
8. Business Visits
Foreign exchange may be released for undertaking business travel or attending a
conference or specialised training or for maintenance expenses of a patient going
abroad for medical treatment or checkup abroad or for accompanying as attendant to a
patient going abroad for medical treatment/ check up to the limits specified in Schedule
III to the Rules.
9. Period of surrender of foreign exchange

a) In case the foreign exchange purchased for a specific purpose is not utilized for that
purpose, it could be utilized for any other eligible purpose for which drawal of
foreign exchange is permitted under the relevant Rules/ Regulation.
b) General permission is available to any resident individual to surrender received/
realised/ unspent/ unused foreign exchange to an Authorised Person within a period
of 180 days from the date of receipt/ realisation/ purchase/ acquisition/ date of
return of the traveler, as the case may be.
c) The liberalized uniform time limit of 180 days is applicable only to resident
individuals and in areas other than export of goods and services.

Page |5
d) In all other cases, the regulations/ directions on surrender requirement shall remain
unchanged.
10. Unspent Foreign Exchange

a) As stated above, unspent foreign exchange brought back to India by a resident
individual should be surrendered to an Authorised Person within 180 days from the
date of return of the traveler. Exchange so brought back can be utilized by the
individual for his/ her subsequent visit abroad.
b) However, a returning traveler is permitted to retain with him, foreign currency
travelers cheques and currency notes up to an aggregate amount of USD 2000 and
foreign coins without any ceiling beyond 180 days. Foreign exchange so retained,
can be utilized by the traveler for his subsequent visit abroad.
c) It may be noted that where a person approaches an A.D. for surrender of unspent/
unutilized foreign exchange after the prescribed period of 180 days, The Authorised
dealer should not refuse to purchase the foreign exchange merely on the ground that
the prescribed period has expired.
d) Resident Indians are also permitted to retain foreign exchange in a foreign currency
account maintained with an AD. Such accounts are called Resident Foreign
Currency Accounts. RFC accounts will be dealt with in detail in Unit No. 7.
11. Remittances for Tour Arrangements

a) A.D.s may remit foreign exchange up to a reasonable limit, at the request of a
traveler towards his hotel accommodation, tour arrangements, etc., in the countries
proposed to be visited by him or for making other tour arrangements for travelers
from India, provided in each case the A.D. is satisfied that the remittance is being
made out of the foreign exchange purchased by the traveler concerned from an
Authorised Person (including exchange drawn for private travel abroad), in
accordance with the Rules, Regulations and Directions in force.
b) A.D.s may effect remittances at the request of agents in India who have tie-up
arrangements with hotels/ agents, etc., abroad for providing hotel accommodation
or making other tour arrangements for travel from India, provided the A.D. is
satisfied that the remittance is being made out of the foreign exchange purchased by
the traveler concerned from an Authorised Person (including exchange drawn for
private travel abroad) in accordance with the Rules, Regulations and Directions in
force.
c) A.D. may open foreign currency accounts in the name of agents in India who have
tie up arrangements with hotels/ agents, etc., abroad for providing hotel
accommodation or making other tour arrangements for travelers from India
provided:-
 The credits to the account are by way of depositing collections made in foreign
exchange from travelers; and refunds received from outside India on account of
cancellation of booking tour arrangements, etc.,and
 The debits in foreign exchange are for making payments towards hotel

Page |6
accommodation, tour arrangements, etc., outside India.

d) A.D. may allow tour operators to remit the cost of rail/ road/ water/ transportation
charges outside India without any prior approval from the RBI, net of commission/
mark up due to the agent. The sale of passes/ ticket in India can be made either
against the payment in Indian Rupees or in foreign exchange released for visits
abroad. The cost of passes/ tickets collected in Indian Rupees need not be adjusted
in the travelers‟ entitlement of foreign exchange for private visit.
e) In respect of consolidated tours arranged by travel agents in India for foreign
tourists visiting India and neighboring countries like Nepal, Bangladesh, Sri Lanka,
etc., against advance payments/ reimbursement through an A.D., part of the foreign
exchange received in India against such consolidated tour arrangement, may require
to be remitted from India to these neighboring countries for services rendered by
travel agents and hoteliers in these countries. A.D. may allow such remittances after
verifying that the amount being remitted to the neighboring countries (inclusive of
remittances, if any, already made against the tour) does not exceed the amount
actually remitted to India and the country of residence of the beneficiary is not
Pakistan.
12. Release of Foreign Exchange Against Payment of Rupees

A.D.s may accept payment in cash up to ₹ 50,000 (Rupees fifty thousand only) against
sale of foreign exchange for travel abroad (for private visit or for any other purpose).
Wherever the sale of foreign exchange exceeds the amount equivalent to ₹50,000, the
payment must be received only by:
a) A crossed cheque drawn on the applicant‟s bank account.
b) A crossed cheque drawn on the bank account of the firm/ company sponsoring the
visit of the applicant.
c) Banker‟s Cheque/ Pay Order/ Demand Draft.
d) Debit/ credit/ prepaid cards provided-
 KYC/AML guidelines are complied with.
 sale of foreign currency/ issue of foreign currency TCs is within the limits
(credit- /- prepaid cards) prescribed by the bank and
 The purchaser of foreign currency/ foreign currency TCs and the credit/ debit/
prepaid card holder is one and the same person.
Note: Where the rupee equivalent of foreign exchange drawn exceeds ₹ 50,000 either
for any single drawal or more than one drawal reckoned together for a single journey/
visit, it should be paid by cheque or draft.
13. Issue of Guarantee – Import of services

a) With a view to further liberalize the procedure (other than in respect of a Public
Sector Company or a Department/ Undertaking of the Government of India/ State
Governments) for import of services, the limit for issue of guarantee by AD
Category-I Banks has been increased from USD 100,000 to USD 500,000.

Page |7
b) Accordingly, AD Category-I banks are now permitted to issue guarantee for

amount not exceeding USD 500,000 or its equivalent in favor of a non-resident
service provider, on behalf of a resident customer who is a service importer,
provided-
 The AD Category-I bank is satisfied about the bonafide of the transaction;
 The AD Category-I bank ensures submission of documentary evidence for
Import of services in the normal course; and
 The guarantee is to secure a direct contractual liability arising out of a contract
between a resident and a non-resident.
c) In the case of a Public Sector Company or a Department/ Undertaking of the
Government of India/ State Governments, approval from the Ministry of Finance,
Government of India for issue of guarantee for an amount exceeding USD 100,000
(USD One hundred thousand) or its equivalent would be required.
Note: In case of invocation of the guarantee, the A.D. is required to submit to the Chief
General Manager-in-Charge, Foreign Exchange Department, Foreign Investments Division
(EPD), Reserve Bank of India, Central Office, Mumbai-400001, a report on the
circumstances leading to the invocation of the guarantee.
Foreign remittance can be paper based or can be electronic remittance. The different forms
of foreign outward remittances are Traveler‟s cheques [TCs], Demand draft [DDs], Money
transfer [MTs], Telegraphic transfers [TTs] or Foreign Currency Payment [FCP] through
International credit cards (ICCs), debit cards, store value cards, charge cards, smart cards.
Foreign Exchange Management (Current Account Transactions) Rules, 2000

The Foreign Exchange Management (Current Account Transactions) Rules, 2000 came
into effect on the 1st day of June 2000. The rules broadly lay down the guidelines with
respect to drawings of foreign exchange.
The key aspects of the rules are as given below-
1. Drawal of foreign exchange by any person for the following purpose is prohibited:
a) Transaction specified in the Schedule I of FEMA; or
b) Travel to Nepal and/ or Bhutan; or
c) Transaction with a person resident in Nepal or Bhutan.
Provided that the prohibition in clause (c) may be exempted by RBI subject to such
terms and conditions as it may consider necessary to stipulate by special or general
order.
2. No person shall draw foreign exchange for a transaction included in the Schedule II
without prior approval of the Government of India. Provided that this rule shall not
apply where the payment is made out of funds held in Resident Foreign Currency
(RFC) Account of the remitter.

Page |8
3. No person shall draw foreign exchange for a transaction included in the Schedule III
without prior approval of the Reserve Bank. Provided that this Rule shall not apply
where the payment is made out of funds held in Resident Foreign Currency (RFC)
Account of the remitter.
Schedule I
Transactions which are prohibited-
1. Remittance out of lottery winnings.
2. Remittance of income from racing/ riding etc. or any other hobby.
3. Remittance for purchase of lottery tickets, banned/ proscribed magazines, football
pools, sweepstakes, etc.
4. Payment of commission on exports made towards equity investment in Joint

Ventures, Wholly Owned Subsidiaries abroad of Indian companies.
5. Remittance of dividend by any company to which the requirement of dividend

balancing is applicable.
6. Payment of commission on exports under Rupee State Credit Route, except

Commission up to 10% of invoice value of exports of tea and tobacco.
7. Payment related to "Call Back Services" of telephones.
8. Remittance of interest income on funds held in Non-Resident Special Rupee

(Account) Scheme.
Schedule II
Transactions which require prior approval of the Central Government-
1. Cultural Tours Ministry of Human Resources Development, (Department of
Education and Culture).
2. Advertisement in foreign print media for the purposes other than promotion of
tourism, foreign investments and international bidding (exceeding USD 10,000)
by a State Government and its Public Sector Undertakings, Ministry of Finance,
(Department of Economic Affairs).
3. Remittance of freight of vessel chartered by a PSU Ministry of Surface Transport,
(Chartering Wing).
4. Payment of import through ocean transport by a Govt. Department or a PSU on
c.i.f. basis (i.e. other than f.o.b. and f.a.s. basis) Ministry of Surface Transport,
(Chartering Wing).
5. Multi-modal transport operators making remittance to their agents abroad
Registration Certificate from the Director General of Shipping

Page |9
6. Remittance of hiring charges of transponders by-

a) TV Channels
b) Internet Service providers
c) Ministry of Information and Broadcasting
d) Ministry of Communication and Information Technology
7. Remittance of container detention charges exceeding the rate prescribed by
Director General of Shipping Ministry of Surface Transport (Director General of
Shipping)
8. Remittance of prize money/ sponsorship of sports activity abroad by a person

other than International/ National/ State Level sports bodies, if the amount
involved exceeds USD 100,000.
9. Ministry of Human Resources Development (Department of Youth Affairs

Sports).
10. Remittance for membership of P&I Club Ministry of Finance (Insurance
Division).
Schedule III
Transactions which require prior approval of the RBI-
1. Release of exchange exceeding US$ 10,000 or its equivalent in one financial year,
for one or more private visits to any country (except Nepal and Bhutan).
2. Gift remittance exceeding US$ 5,000 per financial year per remitter or donor other
than resident individual.
3. Donation exceeding US$ 5000 per financial year per remitter or donor other than
resident individual.
Donations by Corporate, exceeding one per cent of their exchange earnings during
the previous three financial years or US$ 5,000,000, whichever is less, for creation
of Chairs in reputed educational institutes, to funds (not being an investment fund)
promoted by educational institutes; and to a technical institution or body or
association in the field of activity of the donor company.
Explanation: For the purpose of the item numbers [I] and [II] remittance of gift
and donation by resident individuals are subsumed under the liberalized
Remittance Scheme.
4. Exchange facilities exceeding USD 100,000 for persons going abroad for
employment.
5. Exchange facilities for emigration exceeding USD 100,000 or amount prescribed

by country of emigration.
6. Remittance for maintenance of close relatives.

P a g e | 10
Liberalised Remittance Scheme (LRS)

Liberalised Remittance Scheme (LRS) of USD 250,000 for Resident Individuals under
Foreign Exchange Management Scheme [FEMA] 1999
The RBI had announced a liberalised remittance scheme (the Scheme) in February 2004 as
a step towards further simplification and liberalisation of the forex facilities available to
resident individuals.
As per the Scheme, currently, resident individuals may remit up to US$ 250,000 per
financial year for any permitted capital and current account transactions or a combination
of both. It is however not available for purposes specifically prohibited or regulated by the
Government of India.
The facility is available to resident individuals only. Under the Scheme, resident
individuals can acquire and hold immovable property or shares or debt instruments or any
other assets outside India, without prior approval of the RBI. Individuals can also open,
maintain and hold foreign currency accounts with banks outside India.
Key features of the scheme are-

1. Under the Liberalised Remittance Scheme, A.D.s may freely allow remittances by
resident individuals up to USD 250,000 per financial year (April-March) for any
permitted current or capital account transactions or a combination of both.
2. The Scheme is available to all resident individuals including minors. In case of remitter
being a minor, the LRS declaration form should be countersigned by the minor‟s
natural guardian.
3. Remittances under the Scheme can be consolidated in respect of family members
subject to individual family members complying with its terms and conditions.
4. Remittances under the Scheme are allowed only in respect of permissible current or
capital account transactions or a combination of both. All other transactions which are
otherwise not permissible under FEMA and those in the nature of remittance for
margins or margin calls to overseas exchanges/ overseas counterparty are not allowed
under the Scheme.
5. Resident individuals are free to acquire and hold shares or debt instruments or any
other asset including immovable property outside India without prior approval of the
Reserve Bank.
6. The limit of USD 250,000 under the Scheme also includes remittances towards gift and
donation by a resident individual.
7. Remittances under the Scheme can be used for purchasing objects of art subject to the
provisions of other applicable laws such as the extant Foreign Trade Policy of the
Government of India.
8. The Scheme can also be used for remittance of funds for acquisition of ESOPs. The
Scheme is in addition to acquisition of ESOPs linked to ADR/ GDR and acquisition of
qualification shares.

P a g e | 11
9. A resident individual is permitted to make a rupee gift/ loan to a NRI/ PIO who is a
close relative of the resident individual [close relative as defined in Section 6 of the
Indian Companies Act, 1956]. The gift/ loan amount should be within the overall limit
of USD 250,000 per financial year as permitted under the Liberalised Remittance
Scheme (LRS) for a resident individual. It would be the responsibility of the resident
donor/ lender to ensure that the gift/ loan amount is under the LRS and all the
remittances under the LRS during the financial year including the gift/ loan amount
have not exceeded the limit prescribed under the LRS. It may be observed that only
LRS limit of the remitter would be utilized and gift/ loan amount as the case may be
would actually be credited to NRO A/c. of NRI/ PIO close relative.
10. A resident individual can invest in units of Mutual Funds, Venture Capital Funds,
unrated debt securities, promissory notes, etc. under this Scheme. Further, the resident
can invest in such securities out of the bank account opened abroad under the Scheme
11. An individual who has availed of a loan abroad while as a non-resident can repay the
same on return to India under the Scheme as a resident.
12. The Scheme can be used for outward remittance in the form of a DD either in the
resident individual‟s own name or in the name of beneficiary with whom he intends
putting through the permissible transactions at the time of private visit abroad, against
self-declaration of the remitter in the format prescribed.
13. With effect from August 05, 2013, this Scheme, can be used by Resident individuals to
set up Joint Ventures (JV)/ Wholly Owned Subsidiaries (WOS) outside India for
bonafide business activities within the limit of USD 250,000 subject to the terms &
conditions stipulated in FEMA Notification No.263.
14. Individuals can also open, maintain and hold foreign currency accounts with a bank
outside India for making remittances under the Scheme without prior approval of the
Reserve Bank. The foreign currency accounts may be used for putting through all
transactions connected with or arising from remittances eligible under this Scheme.
15. Banks should not extend any kind of credit facilities to resident individuals to facilitate
remittances under the Scheme.
16. The scheme is not available for remittances for any purpose specifically prohibited or
restricted under Foreign Exchange Management (Current Account Transaction) Rules,
2000.
17. The facility is not available for making remittances directly or indirectly to Bhutan,
Nepal, Mauritius and Pakistan.
18. The Scheme is not available for remittance to countries identified by Financial Action
Task Force (FATF) as non-co-operative countries and territories as available on FATF
website www.fatf-gafi.org. or as notified by the Reserve Bank.
Note
1. For undertaking transactions under the Scheme, resident individuals may use the
prescribed application-cum-Declaration Form and it is mandatory to have PAN number
to make remittances under the Scheme.
2. Investors who have remitted funds under LRS can retain, reinvest the income earned on
the investments.

P a g e | 12
Remittance facilities for Non-Resident Indians/ Persons of Indian Origin

Remittance facilities for Non-Resident Indians (NRIs)/ Persons of Indian Origin (PIO) and
Foreign Nationals under the FEMA 1999 are given below.
1. Remittance of funds from the sale of capital assets in India held by a person, whether
resident in or outside India, requires approval of the Reserve Bank except to the extent
provided in FEMA or Rules or Regulations made there under.
2. A NRI/ PIO as per FEMA

NRI for this purpose is defined as a person resident outside India who is citizen of
India. In terms of Regulation 2 of FEMA Notification No.13 dated May 3, 2000, Non-
Resident Indian (NRI) means a person resident outside India who is a citizen of India.
Person of Indian Origin (PIO) means a citizen of any country other than Bangladesh or
Pakistan who had (a) at any time held Indian passport or (b) he or either of his parents
or any of his grandparents was a citizen of India by virtue of the Constitution of India
or the Citizenship Act, 1955 or (c) the person is a spouse of an Indian citizen or a
person referred to in (a) or (b).
3. Remittance of current income

a) Remittance outside India of current income like rent, dividend, pension, interest,
etc. in India of the account holder is a permissible debit to the NRO account. A.D.
banks may also allow repatriation of current income like rent, dividend, pension,
interest, etc. of NRIs who do not maintain an NRO account in India based on an
appropriate certification by a Chartered Accountant, certifying that the amount
proposed to be remitted is eligible for remittance and that applicable taxes have
been paid/ provided for.
b) NRIs/ PIO have the option to credit the current income to their Non-Resident
(External) Rupee account, provided the Authorized Dealer bank is satisfied that the
credit represents current income of the non-resident account holder and income tax
thereon has been deducted/ provided for.
c) Foreign nationals who come to India on employment and become residents in terms
of section 2 (v) of FEMA, 1999, and are eligible to open/ hold a resident savings
bank account, are permitted to re-designate their resident account maintained in
India as NRO account on leaving the country after their employment to enable them
to receive their legitimate dues subject to certain conditions.
4. Remittance of assets by a foreign national of non-Indian origin

a) A foreign national of non-Indian origin who has retired from an employment in
India or who has inherited assets from a person resident in India or who is a widow
of an Indian citizen who was resident in India, may remit an amount not exceeding
USD one million, per financial year (April-March), subject to the satisfaction of the
A.D. bank, on production of documentary evidence in support of acquisition/
inheritance of assets and information in the formats prescribed by the Central Board

P a g e | 13
of Direct Taxes, Ministry of Finance, Government of India in their Circular No.

10/2002 dated October 9, 2002 [cf. A.P.(DIR Series) Circular No. 56 dated
November 26, 2002].
b) These remittance facilities are not available to citizens of Nepal and Bhutan.
c) When a person resident in India leaves India for a country (other than Nepal or
Bhutan) for employment/ business/ vocation outside India or with an intention to
stay outside India, his/ her existing account is re-designated as NRO account.
In order to facilitate foreign nationals to collect their pending dues in India, AD

Category-I banks may permit such foreign nationals to re-designate their resident
account maintained in India as NRO account on leaving the country after their
employment to enable them to receive their pending bona fide dues, subject to the
following conditions:
a) AD Category-I bank should obtain the full details from the account holder about his
legitimate dues expected to be received into his account.
b) AD Category-I bank has to satisfy itself as regards the credit of amounts which
have to be bonafide dues of the account holder when she/ he was a resident in India.
c) The funds credited to the NRO account should be repatriated abroad immediately,
subject to the AD Category-I bank satisfying itself regarding the payment of the
applicable Income tax and other taxes in India.
d) The amount repatriated abroad should not exceed USD one million per financial
year.
e) The debit to the account should be only for the purpose of repatriation to the
account holder‟s account maintained abroad.
f) There should not be any other inflow/ credit to this account other than that
mentioned at point (a) above.
g) AD Category-I bank should put in place proper internal control mechanism to
monitor the credits and debits to this account.
h) The account should be closed immediately after all the dues have been received and
repatriated as per the declaration made by the account holder mentioned at
paragraph (a) above.
5. Remittance of assets by NRI/PIO

a) A Non-Resident Indian (NRI) or a Person of Indian Origin (PIO) may remit an
amount up to USD one million, per financial year, out of the balances held in his
Non- Resident (Ordinary) Rupee (NRO) account/ sale proceeds of assets (inclusive
of assets acquired by way of inheritance or settlement), for all bonafide purposes,
subject to the satisfaction of the Authorized Dealer bank and in the formats
prescribed by the Central Board of Direct Taxes, Ministry of Finance, Government
of India in their Circular No. 10/ 2002 dated October 9, 2002 [cf. A.P.(DIR Series)
Circular No. 56 dated November 26, 2002].
b) NRI/PIO may remit sale proceeds of immovable property purchased by him out of
Rupee funds (or as a person resident in India) as indicated in paragraph 5.1 above

P a g e | 14
without any lock-in-period.

c) In respect of remittance of sale proceeds of assets acquired by way of inheritance or
legacy or settlement for which there is no lock-in period, NRI/ PIO may submit to
the A.D. documentary evidence in support of inheritance or legacy of assets, an
undertaking by the remitter and certificate by a Chartered Accountant in the
prescribed formats. Settlement is also a mode of inheritance from the parent, the
only difference being that the property under the settlement passes to the
beneficiary on the death of the owner/ parent without any legal procedures/ hassles
and helps in avoiding delay and inconvenience in applying for probate, etc. In case
settlement is done without retaining any life interest in the property i.e. during the
lifetime of the owner/ parent, it would be tantamount to regular transfer by way of
gift. Therefore, if the property is received by NRI/ PIO by way of settlement
without the settler retaining life interest, it may be reckoned as transfer by way of
gift and the remittance of sale proceeds of such property would be guided by the
extant instructions on remittance of balance in the NRO account.
d) The remittance facility in respect of sale proceeds of immovable property is not
available to citizens of Pakistan, Bangladesh, Sri Lanka, China, Afghanistan, Iran,
Nepal and Bhutan.
e) A person or his successor who has acquired immovable property in accordance with
Section 6(5) of FEMA, 1999 cannot repatriate sale proceeds of such property
outside India except with prior permission of the Reserve Bank.
f) The facility of remittance of sale proceeds of other financial assets is not available
to citizens of Pakistan, Bangladesh, Nepal and Bhutan.
6. Remittance of Salary
a) A citizen of a foreign state resident in India, being an employee of a foreign
company and on deputation to the office/ branch/ subsidiary/ joint venture in India
of such foreign company or being an employee of a company incorporated in India,
may open, hold and maintain a foreign currency account with a bank outside India
and receive/ remit the whole salary payable to him for the services rendered, by
credit to such account, provided that income tax chargeable under the Income Tax
Act, 1961 is paid on the entire salary as accrued in India.
b) A citizen of India, employed by a foreign company outside India and on deputation
to the office/ branch/ subsidiary/ joint venture in India of such foreign company,
may open, hold and maintain a foreign currency account with a bank outside India
and receive the whole salary payable to him for the services rendered to the office/
branch/ subsidiary/ joint venture in India of such foreign company, by credit to such
account, provided that income tax chargeable under the Income Tax Act, 1961 is
paid on the entire salary as accrued in India. [The above provisions on remittance of
Salary should be read with Schedule III (7) of FEM (Current Account Transactions)
Rules, 2000]

P a g e | 15
7. Repatriation of sale proceeds of residential property purchased by NRIs/ PIO out

of foreign exchange
a) Repatriation of sale proceeds of residential property purchased by NRI/PIO is
permitted to the extent of the amount paid for acquisition of immovable property in
foreign exchange received through banking channels. The facility is restricted to
not more than two such properties. The balance amount can be credited to the NRO
account and can be remitted upto USD one million.
b) A.D. banks may permit repatriation of amounts representing the refund of
application/ earnest money/ purchase consideration made by the house building
agencies/ seller on account of non-allotment of flat/ plot/ cancellation of bookings/
deals for purchase of residential/ commercial property, together with interest, if any
(net of income tax payable thereon), provided the original payment was made out of
NRE/ FCNR (B) account of the account holder, or remittance from outside India
through normal banking channels and the Authorized Dealer bank is satisfied about
the genuineness of the transaction. Such funds may also be credited to the NRE/
FCNR (B) account of the NRI/ PIO, if they so desire.
c) A.D. banks may allow repatriation of sale proceeds of residential accommodation
purchased by NRIs/ PIO out of funds raised by them by way of loans from the
authorized dealer banks/ housing finance institutions to the extent of such loan/s
repaid by them out of foreign inward remittances received through normal banking
channel or by debit to their NRE/ FCNR(B) accounts.
8. Facilities for students

a) Students going abroad for studies are treated as Non- Resident Indians (NRIs) and
are eligible for all the facilities available to NRIs under FEMA.
b) As non-residents, they will be eligible to receive remittances from India:
 Up to USD 100,000 from close relatives in India, on self-declaration, towards
maintenance, which could include remittances towards their studies also.
 Up to USD 1 million per financial year, out of sale proceeds of assets/ balances
in their NRO account maintained with an A.D. bank in India.
 Up to limits prescribed under the Liberalized Remittance Scheme.
c) All other facilities available to NRIs under FEMA are equally applicable to the
students.
d) Educational and other loans availed of by them as residents in India will continue to
be available as per FEMA regulations.
9. Income-tax clearance
The remittances will be allowed to be made by the Authorized Dealer banks on
production of an undertaking by the remitter and a certificate from a Chartered
Accountant in the formats prescribed by the Central Board of Direct Taxes, Ministry of
Finance, Government of India in their Circular No. 10/ 2002 dated October 9, 2002 [cf.
A.P. (DIR Series) Circular No. 56 dated November 26, 2002].

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10. International Credit Cards

A.D. banks have been permitted to issue International Credit Cards to NRIs/ PIO,
without prior approval of the Reserve Bank. Such transactions may be settled by
inward remittance or out of balances held in the cardholder‟s FCNR(B)/ NRE/ NRO
accounts.
Exchange houses and drawing arrangements

RBI guidelines for opening and maintenance of Rupee/ foreign currency vostro accounts of
non-resident Exchange houses in India are as follows-
1. Under the Rupee Drawing Arrangements (RDAs), cross-border inward remittances are
received in India through Exchange Houses situated in Gulf countries, Hong Kong, and
Singapore.
2. All other countries which are FATF compliant only under Speed Remittance Procedure.
Key aspects-
1. While considering the request of an Exchange House for opening an account in India, the
AD Category-I banks concerned should make necessary enquiries about the financial
standing of the Exchange House, in accordance with the normal banking practices and
satisfy themselves fully in all respects. AD Category-I banks should also ensure that the
Exchange Houses hold valid licenses issued by the Local Monetary/ Supervisory
Authority concerned and have necessary authority/ license to transact currency exchange/
money transfer business in their respective countries.
2. The requirement of registration of the Agreement between the AD Category-I banks and
Exchange Houses under the Rupee Drawing Arrangement/ Foreign Currency Drawing
Arrangement has been made optional. However, such arrangements should be subjected
to comprehensive legal documentation and AD Category-I banks should take care of all
necessary legal requirements in this regard. Further, it should be ensured that all the
partners of the Exchange Houses are jointly and severally bound to honour the obligations
devolving on the Exchange Houses under the agreement.
The normal banking requirements of registration of Power of Attorney/ specimen signatures

of signing officials of the Exchange Houses should be observed.
Drawing Arrangements
Drawing arrangements with Exchange Houses are primarily designed to channel cross-border
inward personal remittances. Under no circumstances, donations/ contributions to charitable
institutions should be routed through the Exchange Houses.
The following is the list of permissible transactions under Drawing Arrangements with
Exchange Houses-
1. Credit to Non-resident (External) Rupee accounts maintained by Non-Resident Indians in

P a g e | 17
Indian Rupees.
2. Payments to families of Non-resident Indians.
3. Payments in favour of Insurance companies, Mutual Funds and the Post Master for
premia/ investments.
4. Payments in favour of bankers for investments in shares, debentures.
5. Payment to Co-operative Housing Societies, Government Housing Schemes or Estate
Developers for acquisition of residential flats in India in individual names, subject to
compliance of regulations applicable thereof, by the Non-resident Indians.
6. Payments of tuition/ boarding, examination fee, etc., to schools, colleges and other
educational institutions.
7. Payments to medical institutions and hospitals in India, for medical treatment of NRIs /
their dependents and nationals of all FATF countries.
8. Payments to hotels by Nationals of all FATF compliant countries/ NRIs for their stay.
9. Payments to travel agents for booking of passages of NRIs and their families residing in
India towards their travel in India by domestic airlines/ rail, etc.
10. Trade transactions up to ₹ 15,00,000 (Rupees Fifteen lakhs only) per transaction is
permitted.
Further, it has been decided to permit AD banks to regularize payments exceeding the
permitted limit under RDA provided that they are satisfied with the bonafide of the
transaction.
They must take additional steps as under-
1. AD banks must ensure the remittances received under RDA are from FATF compliant
countries, KYC/ AML/ CFT and other due diligence concerns should be taken care of by
AD banks.
2. Individual Exchange houses which are frequently sending large value trade related
remittances must be reviewed and reported to the Reserve Bank of India.
3. AD banks must contact their correspondents that maintain accounts for, or facilitate
transactions on behalf of Exchange Houses in order to request additional information
regarding high value trade related transactions and the parties involved. The collected
details should be kept on record and it may be made available for scrutiny,
4. AD banks must ensure that the proceeds of export payment through RDA is applied to the
outstanding export finance if any, availed by the exporter from any bank for the export
transaction concerned and obtain a declaration to that effect from the exporter.
5. Payments to utility service providers in India, for services such as water supply,
electricity supply, telephone (except for mobile top-ups), internet, television, etc.
6. Tax payments in India.
7. EMI payments in India to Banks and Non-Banking Financial Companies (NBFCs) for
repayment of loans.
8. Remittances to the Prime Minister‟s National Relief Fund subject to the condition that the
remittances are directly credited to the Fund by the banks and the banks maintain full
details of the remitters.
9. No cash disbursement of remittances received is allowed under Rupee/ Foreign Currency

P a g e | 18
Drawing Arrangements.
Rupee Drawing Arrangement Procedures and Collateral Cover

Rupee Drawing Arrangements can be conducted under-
1. Designated Depository Agency (DDA).
2. Non-Designated Depository Agency (Non-DDA).
3. Speed Remittance procedures.
1. Designated Depository Agency (DDA) Procedure

a) The Exchange House will be required to open a bank account in a convertible foreign
currency (known as DDA account) in the name of the drawee bank (a/c- Exchange
House) with an international bank acceptable to the drawee bank at a centre mutually
agreed upon or with the drawee bank itself at the branch where the corresponding Rupee
vostro account is maintained, with the prior approval of the Reserve Bank.
b) The Exchange House will, at the end of each day, arrive at the total drawings in Indian
Rupees for the day and will convert the same into foreign currency which shall be
deposited into the account of the drawee bank (a/c-Exchange House) [known as DDA
account, as described at 1(a) above] on the next working day before noon.
c) The Exchange House will send to the drawee bank information about the total number
and the aggregate value of drafts drawn and daily deposits in the DDA account. Transfer
from the DDA account should be as frequently as possible and is subject to the stipulation
as at 1(e) below.
d) The funds will be held in the DDA account under lien to the drawee bank. The only debits
allowed from the DDA account will be (i) on account of transfer to the nostro account of
the drawee bank where the DDA account is maintained with a bank other than the drawee
bank, (ii) for crediting the Rupee vostro account of the Exchange House by selling
permitted foreign currency to the drawee bank where the DDA account is maintained
with the drawee bank.
e) It will be the responsibility of the Exchange House to arrange for the transfer of the sum
collected on any particular day to the DDA account. The float period for the funds with
DDA account will be decided by the drawee bank in consultation with the Exchange
House subject to a maximum of five days.
f) The interest earned on the amount deposited by the Exchange House with the DDA as
provided for at 1 (b) above, up to the date of transfer to the nostro account of the drawee
bank will accrue to the Exchange House.
g) To ensure compliance of the above, the drawee bank in India will appoint a firm of
practising Chartered Accountants/ Auditors, operating in the country concerned to
examine the daily drawings and deposits in the accounts with the DDA as well as transfer
to the nostro account of the drawee bank. For this purpose, the Exchange House will
undertake to allow the auditors to inspect the books, pay in vouchers, etc., of the
Exchange House in so far as they pertain to Rupee drawing arrangement. Such
inspections will be done at least once or twice every week by the auditors.
h) As an alternative to the appointment of auditors as mentioned in paragraph 1(g) above,

P a g e | 19
the AD Category-I bank may depute a suitable official as their representative to the
Exchange House to take up such functions so as to safeguard the interests of the AD
Category-I bank.
i) The auditors/ representative will promptly report the findings to the drawee bank. In case
of default on the part of the Exchange House, the drawee bank will as per terms and
conditions of agreement, terminate the agency arrangement under notice to the Exchange
House. The termination will also be promptly reported to the Reserve Bank.
j) So long as the Exchange House complies with the guidelines, the drawee bank will ensure
that the drafts issued are honoured at the branches mutually agreed to.
k) The remuneration payable to the auditors will be borne by the drawee banks. (l) Drafts
drawn by the Exchange House should have a validity of only three months from the date
of issue thereof.
l) AD Category-I banks should satisfy themselves that the books of accounts of Exchange
Houses are regularly audited by auditors approved by the local supervisory authorities.
m) AD Category-I banks should call for periodical credit reports, audited balance sheet and
profit and loss account of the Exchange House and other relevant information so as to
take a decision regarding continuance of accounts in their books.
n) Valid copies of all licenses should also be kept on record by the AD Category-I bank.
o) Since the books of accounts of the Exchange House cannot be inspected, AD Category-I
banks should periodically review the arrangement by paying visits to the Exchange
Houses and/ or by periodical review of opinion reports. The visits of officials from AD
Category-I banks should be at a sufficiently senior level, who are fully conversant with
the conduct of the Non-resident Rupee Accounts of the Exchange Houses.
p) Collateral Cover for DDA: For Exchange Houses which have not completed three years
of operation, collateral cover in cash deposit in any convertible foreign currency or
guarantee from a bank of international repute equivalent to 7 days‟ projected drawings
may be obtained. For Exchange Houses which have completed three years of successful
operations, no collateral is prescribed. However, AD Category-I banks may secure their
position by acquiring adequate collateral cover. Cash deposit in any convertible foreign
currency or a guarantee from a bank of international repute equivalent to 15 days‟
estimated drawings may be obtained as collateral cover where it is not possible to appoint
auditors as mentioned at 1(g) above. The deposit should be in the name of the AD
Category-I bank with interest thereon at market related rates payable to the Exchange
House placing the deposits. The amount of deposit and guarantee should be periodically
reviewed and properly monitored by the AD Category-I banks to ensure that the collateral
covers adequately the drawings.
2. Non- DDA procedure

a) As an alternative to maintaining a DDA account and appointment of auditors as
above, the AD Category-I banks may opt for the Non-DDA procedure.
b) Under Non–DDA procedure, the Exchange House funds their vostro account with the
AD Category-I banks by purchasing rupees from the AD Category-I banks against
USD for the total of drafts issued by them at periodic intervals and sends weekly

P a g e | 20
statements of drawing and funding to the AD Category-I banks.

c) Collateral Cover for Non-DDA: For Exchange Houses which have not completed
three years of operation, collateral cover in cash deposit in any convertible foreign
currency or guarantee from a bank of international repute equivalent to 7 days‟
projected drawings may be obtained. For Exchange Houses which have completed
three years of successful operations, no collateral is prescribed. Further, under Non-
DDA arrangement, a collateral cover in cash deposit in any convertible foreign
currency or guarantee from a bank of international repute equivalent to 10 days‟
projected drawings may be obtained from Exchange Houses. In addition to the above,
if there is a restriction on the bank‟s right to depute its own staff for examination of
books of the Exchange House, as was in case of Exchange Houses in Kuwait,
additional cash deposit in any convertible foreign currency/ guarantee from a bank of
international repute equivalent to 15 days‟ estimated drawings may be obtained. The
deposit should be in the name of the AD Category-I bank with interest thereon at
market related rates payable to the Exchange House placing the deposits. The amount
of deposit and guarantee should be periodically reviewed and properly monitored by
the AD Category-I banks to ensure that the collateral adequately covers the drawings
and account for the pipeline debits evaluated.
3. Speed Remittance Procedure

a). AD Category-I banks are permitted to enter into RDA under speed remittance
procedure wherein-
i. The Exchange House sends payment instructions with complete details like name,
address, etc., via SWIFT or internet.
ii. The Exchange House funds the Rupee account through the nostro account of the
AD Category-I bank well in advance before issuing payment instructions.
iii. On verification of data and availability of balances in the vostro account of the
exchange house the AD Category-I bank issues drafts in favour of the beneficiary
or credits the account of the beneficiary.
iv. The Exchange House shall address all payment instructions to the account holding
branch of the AD Category-I bank irrespective of the beneficiaries‟ centre.
v. The branch shall make no payment unless clear funds are available in the account.
vi. The AD Category-I bank shall obtain date-wise information regarding number and
aggregate value of such transfers from the Exchange House.
vii. Where facility of speed remittance is extended to existing Rupee drawing
arrangements, the Exchange House shall open a separate Rupee account with the
prior approval of the Reserve Bank and no payment instructions shall be executed
unless there are clear funds available in this account. However, where the
operations in the existing Rupee drawing arrangements under DDA/ Non-DDA
procedure are satisfactory, AD Category-I banks can extend the facility of speed
remittance to the same Exchange House without prior approval of the Reserve
Bank, subject to usual terms and conditions and after obtaining all the necessary
documents from the Exchange House. However, the Reserve Bank should be

P a g e | 21
informed in the matter immediately.

b). Collateral Cover for Speed Remittance Arrangement: For Exchange Houses,
which have not completed three years of operation, collateral cover in cash deposit in
any convertible foreign currency or guarantee from a bank of international repute
equivalent to 7 days‟ projected drawings may be obtained. For Exchange Houses,
which have completed three years of successful operations, no collateral is prescribed.
Further, the Exchange House shall keep with the AD Category-I bank an additional
cash deposit in any convertible foreign currency or guarantee from a bank of
international repute equivalent to 1 day‟s estimated drawings. The deposit should be
in the name of the AD Category-I bank with interest thereon at market related rates
payable to the Exchange House placing the deposits. The amount of deposit and
guarantee should be periodically reviewed and properly monitored by the AD
Category-I banks.
Foreign currency - Drawing arrangements

AD Category-I banks may enter into foreign currency drawing arrangements under DDA or
Non-DDA procedure with those Exchange Houses with whom they have Rupee Drawing
Arrangements (RDAs), with prior approval of the Reserve Bank, subject to the following
conditions.
Each tie-up arrangement of an AD Category-I bank with an Exchange House under Foreign
Currency Drawing Arrangements is required to be approved by the Reserve Bank.
Key aspects-
1. Exchange houses shall draw drafts in any convertible foreign currency on „A‟ or „B‟
category branches of AD Category-I bank. No „C‟ category branch is allowed to
participate in the arrangement.
2. The foreign currency drawing arrangement shall be kept distinct from the Rupee drawing
arrangement.
3. A separate foreign currency vostro account of the Exchange House shall be opened with
the account maintaining branch. Payment of such drafts shall be made by debit to this
account maintained by the Exchange House and not to the nostro Account of the AD
Category-I bank.
4. The aggregate amount of drafts drawn in foreign currency by the Exchange House on any
day should be credited to the nostro Account of the drawee bank latest by close of
business on the second working day.
5. The account maintaining branch of the drawee AD Category-I bank should credit foreign
currency vostro account of the Exchange House on receipt of confirmation regarding
credit to their nostro account.
6. AD Category-I banks should ensure that foreign currency accounts are funded at all
times.
7. If the arrangement is under the Non-DDA procedure, the Exchange House should
communicate to the account maintaining branch by any electronic mode, the number and

P a g e | 22
aggregate value of drafts drawn in foreign currency before close of the following working
day. Under DDA procedure, such information may be obtained frequently, at least on a
bi-weekly basis.
8. Collateral cover: Exchange Houses should keep a deposit of not less than USD 50,000
with the drawee AD Category-I bank. Adequacy of quantum of deposit kept with the
bank should be reviewed every six months on the basis of operations under this
arrangement and if necessary the Exchange House should increase the quantum of the
deposit. AD Category-I banks should allow interest on this deposit at an appropriate rate.
9. AD Category-I banks are allowed to keep the amount of deposit required to be kept under
foreign currency draft drawing arrangements and Non-DDA procedure of Rupee Drawing
Arrangement in India with the Account maintaining branch.
Canara Bank branded remittance

Western Union Money Transfer (MTSS)
Definition/Purpose
 Money Transfer Service Scheme (MTSS) of RBI is yet another channel for flow of
Remittances into India from abroad. This scheme is designed for transfer of funds for
personal remittances only.
 Only personal remittances shall be allowed under this arrangement. Donations/
Contributions to Charitable Institutions/ Trusts shall not be remitted through this
arrangement. Remittance received under the scheme can be credited only to domestic SB
accounts of Resident Indians.
Features
 RBI has placed a cap of USD 2500 on individual transaction under the scheme. Amounts
up to `.50,000 may be paid in cash. Any amount exceeding this limit shall be paid only by
means of crossed PO/DD or credited to the beneficiary‟s account. Exceptions to this
restriction are for payment to Foreign Tourists visiting India, Foreign Students studying
in India, subject to production of their Passport as identification.
 A single individual can receive only 30 remittances during a year.
 Amount received cannot be repatriated nor credited to NRE or invested in FCNR (B).
 No Foreign Inward Remittance Certificate Can Be Issued For These Remittances.
 Branches should invariably mention the 10 digit MTCN and the name of the beneficiary
in the narration field while debiting the related CASA account maintained with Nariman
Point, Mumbai branch to facilitate easy reconciliation
 Branches to debit directly CASA account number 0172201006234 of M/s Weizmann
Forex Limited.
 Branches have to obtain from the beneficiary „To Receive Money (TRM)‟ form provided
by M/s Weizmann Forex Ltd along with copy of documents establishing identity/address
proof as per AML/KYC procedure.

P a g e | 23
Ref. Circulars
 FX/124/2014 dt 20.11.2014, FX/70/2015
Rupee Drawing Arrangement

Definition
The system of sending drawing advices received from Exchange Houses, containing the
details of draft issued by them for amount beyond specified cut off limit, by Nodal Centers to
drawee branches/offices has been dispensed with. Designated branches/offices should make
the payment of cheques drawn under RDA only by on-line debit to Vostro accounts, by
following the prescribed procedure.
 An arrangement under which Banks/Exchange houses abroad remit funds in Indian
Rupees by drawing drafts/cheques or via electronically.
 This is the most convenient and preferred mode of remittance by Indian expatriates in
Middle East reason.
Other Features
 Canara Bank is having RDA arrangement with 33 exchange houses for receiving Inward
Remittances. Exchange houses are maintaining their INR Vostro accounts with Vostro
Central Processing Centre (CPC), Integrated Treasury, T&IO Wing, Mumbai. They draw
their cheques on our identified drawee branches/offices under the bank‟s product
“RemitMoney” (a web based speed remittance product).
 Drawee branches can make payment of RDA instruments online by matching the issue
data available in CBS and credit the amount to beneficiary account.(IO/03/2012)
 With effect from 01.04.2012, drawee branch concept has been withdrawn in respect of
instruments drawn by exchange houses. Hence all the branches/offices are permitted to
process cheques drawn by exchange houses having RDA with our bank if the instrument
is otherwise order in all respects.
 In respect of processing of instruments drawn by overseas banks under RDA, drawee
branch concept shall continue.
 Foreign Inward remittance received by AD-1 banks may be credited directly to the
beneficiary account electronically using NEFT, IMPS in any KYC compliant bank
account.
 Increase in trade related remittances from Rs.5,00,000.00 to Rs.15,00,000.00 per
transaction. (FX/47/2015)
 Online viewing of Authorised signatures of exchange houses having RDA is made
available through web based package “CASIO” (Canara Signature Images Verification
Online).
Ref. Circulars - IO.75/2010, FX 51/2014
Diamond Dollar Accounts(DDA)

Purpose
 Current Account in Foreign Currency for gems & jewellery exporters

P a g e | 24
Eligibility
 Firms and companies dealing in purchase and sale of rough or cut and polished diamonds
etc., with a track record of at least 2 years in import/export of diamonds, gold jewellery
etc., and having an average annual turnover of Rs.3 crore or above during the preceding
3 licencing years (April to March) can transact their business through DDA.
Other Features
 Currency of the account: Only US Dollar
 Type of account: Only current account (No interest is payable)
 Number of accounts: Maximum 5.
 Intra-Account Transfer: No intra-account transfer should be allowed between the DDAs
maintained by the account holder
 Provisions of Cir IO/98/2012 dt 13.08.2012 apply to DDA accounts also.
Ref. Circulars = Forex Desk Card
Foreign Currency Loan to Residents (FCLR)

Purpose
 Foreign Currency Loan to residents disbursed in rupee.
Eligibility
 To existing Corporate Clients/firms and New Blue Chip Companies ranked with Fortune
500/ EOUs/ PSUs/ NBFCs (AAA rated) with Credit Risk Rating of Low Risk & excellent
track record.
 For productive purpose and not for personal purpose.
 FCLR can be granted to depositor/ third parties against NRE/FCNR (B) fixed deposits
without any ceiling subject to usual margin requirements and as per delegation of credit
sanctioning powers as advised by HO time to time. (IO/130/2012)
Other Features
 Currency: USD, GBP and EURO. Minimum amount USD 2, 50,000 or equivalent in case
of working capital and USD 50,000 in case of short term financing.
 Period: Working Capital: 6 months, Short Term : 3 years
Ref. Circulars - Forex Desk Card updated upto 31/12/2010
Collection of USD Clean Instruments

Purpose
 Collection of clean instruments denominated in USD payable in USA. (Arrangement with
Bank of America NA & Wells Fargo Bank NA)
Facility
 CLS - Cash Letter Services (with recourse) with Bank of America NA
 CLS – Cash Letter Service (with recourse) with Wells Fargo Bank NA
 FCS – Final Credit Service (without recourse) with Wells Fargo Bank NA

P a g e | 25
Features
 Cash Letter Service of Bank of America and Wells Fargo Bank are for cheques drawn in
USD and payable in USA. The service is for clearing USD clean instruments like
Personal Cheques, Traveller‟s cheques, International money orders, Demand Drafts etc.
 In Cash Letter Service, the Bank shall credit our Nostro account with the cheque amount,
however, shall have the right to debit our Nostro account at a later date if the instrument
is found to be fraudulent at a later date.
 Cash Letter Service (with recourse) is extended through the RDC scanners being installed
at four designated FD‟s as per FX/55/2016 through which the cheques are scanned and
images sent online to BOA & Wells Fargo Bank in USA in encrypted format. After
clearance of the same in local clearing service, the amount shall be credited to our Nostro
account with them. After the waiting period of 21 days from the value date, the funds can
be credited to the account holder‟s account as per the instructions given. Cheques for
value upto USD 2,000 shall be processed under this arrangement.
 Under FINAL CREDIT SERVICE (FCS) of Wells Fargo Bank NA, the proceeds of the
cheques will either be credited to our Nostro account (final credit) or a notification of non
payment is sent within a definite time depending upon the location of the drawee bank.
Once the amount of cheque is credited to our Nostro account, the collecting bank i.e.
Wells Fargo Bank NA cannot debit our account or claim refund of the amount of the
cheque at a later date, on account of any alteration on the front of the cheque. This service
of Wells Fargo Bank
 NA is available subject to payment of charges. Under Final Collection Service cheques
for value USD 2,001 to USD 250,000 shall beprocessed.
 At the specific request of the customer, cheques for value upto USD 2,000 also can be
processed under Final Collection Service subject to payment of the applicable charges.
 Under FCS all the branches will send Cheques to their respective FD‟s out of the four
mentioned as per FX/55/2016, which are provided with special slips and are only
authorized to send the same to Wells Fargo, NJ, USA.
Eligibility
 Eligible Instruments: Original, Fully and properly completed and endorsed, Meet
requirements of clearing in the U.S. check clearing system, Be drawn in U.S Dollars, Be
drawn on a Bank in the United States of America, Be drawn for an amount of not less
than US $ 50.00 and not more than US$ 250,000, The payee as well as drawer of the
cheques should not be in the Global Sanction lists.
 Ineligible Instruments :Mutilated items, Stale-dated items, Postdated items, United States
Treasury Checks, United States Postal Money Orders payable in the U.S only,
Photocopies of original checks, Items which have been previously processed or returned.
Ref. Circulars - FX/55/2016, FX/65/2016
AMEX - FCTC - Sales Limit Policy

Purpose

P a g e | 26
 American Express Global Prepaid (AMEX) New York, to comply with the regulatory
requirements, has introduced a Sales Limit Policy.
 As per the Sales Limit Policy of AMEX, value of FCTCs to be sold to individual
travelling customers is restricted to USD 25,000/- (or equivalent in other currencies) per
day, per person.
 Sale of Travellers‟ cheques shall not be to businesses but to individuals only.
 AMEX brand FCTCs is available in USD, EURO, GBP, CAD and AUD currencies.
Ref. Circulars - IO. 62/2009, FX/111/2015
Multi-Currency Gateway
Purpose
 Arrangement with Citibank NA for adopting their product "Multi Currency Gateway
(MCG) Auto Proposal" through which Citibank NA will convert the proceeds of our
SWIFT Payment orders (MT 103) routed through our USD account maintained with
them, into beneficiary's local currency & provides credit to the beneficiary.
Other Features
 Maximum amount of individual payment eligible under the service is USD 50, 000 and
the service is available w.e.f 01.08.2011.
 The service under this product is not available to those branches/ offices, which are not
permitted to operate USD nostro account maintained with Citibank NA. Citibank NA will
reconvert & absorb the re-conversion cost (if any), if an eligible payment is converted to a
local currency and if the same should not have been converted, upon receipt of request
from the beneficiary bank or remitting bank (i.e., our Bank).
Ref. Circulars - IO/66/2011
FX4CASH - Multi Currency Payment Solution

Features
 An arrangement with Deutsche Bank AG through which Deutsche Bank AG will convert
our banks swift outward payment messages (MT103 & MT202) routed through our USD
account maintained with them, into 116+ non position currencies and provides credit to
the beneficiary‟s local currency account.
Other Features
 No maximum ceiling on individual payment and the service is available w.e.f 01.10.2014.
 Mandatory use of code /DBF4C/ in Field 72 of SWIFT MT103 & MT202 sent to
Deutsche Bank America NA, NY SWIFT BIC: BKTRUS33 to the debit to our USD
account 04427255.
 This service is available to all our branches.
 The FX conversions facility will only be used at the request of remitter/customers who
wants to remit the fund in currency other than US Dollars / listed in Annexure II, to
payments meeting the mutually agreed upon parameters prior to the commencement of

P a g e | 27
the service.
 Branches/offices shall not use this facility for our position currencies which are AUD,
CAD, CHF, DKK, EUR, GBP, HKD, JPY, SEK, SGD.
Ref. Circulars - IO/107/2014
Xpress Money
Purpose
 XPRESS MONEY' offers instant remittance facilities from over 90 countries with over
50,000 outlets. Money Transfer product -„Xpress Money' of UAE Exchange Centre LLC,
Abu Dhabi is an ethnic brand of money transfer that offers Cash to Cash Transfer
services. This is a purely Rupee based product with no foreign exchange element
involved.
Availability
 Initially, 265 branches in Karnataka region have been identified for implementation of the
product. Plans to extend to other regions in a phased manner.
 The branches identified to process the transactions under "Xpress Money" product are
required to login to the „Xpress Money' Web site.
 Our DIT Wing has enabled branches to access to this web page
(URL:https://www.xpressmoney.biz/), which can now be accessed through Bank's
Corporate Internet connectivity Arrangement with M/s UAE Exchange & Financial
Services Limited for providing service under Money Transfer Service Scheme (Xpress
Money), which is similar to Western Union Money Transfer Service.
 This arrangement provides opportunity for our branches to increase their clientele base by
identifying non-customer beneficiaries and solicit their accounts to our bank, apart from
increasing the Non-Fund based income of the Bank.
 Under the scheme, only personal remittances to Resident Indians and remittances
favouring Foreign Tourists visiting India are permissible. Repatriation of such inward
remittances received is not permitted.
 For successfully processed transactions in the „ Xpress Money' Website, branches while
making payment to beneficiaries have to debit CASA account number 0404201011977 of
M/s UAE Exchange & Financial Services Limited maintained with our Cantonment (M G
Road) – Bangalore branch (DP 404).
 Upon completion of the process of a transaction in the Xpress Money Web system, the
remitter abroad will receive an SMS alert.
Ref. Circulars - Cir IO/88/2011
Inward and Outward Remittances in Foreign Exchange, its procedural aspects under
FEMA-2000 was one step towards achieving the aim of opening of the economy and
achieving the objectives of a free economy and treading on the path towards free

P a g e | 28
convertibility over a period of time. The monitoring department in RBI which was known
as Exchange Control Department and now known as Foreign Exchange Department.
Unit summary
 Inward and outward remittance in foreign exchange - procedural aspects.
 Foreign Exchange Management (Current Account Transactions) 2000.
 Liberalized Remittance Scheme.
 Exchange houses and drawing arrangements.
 Canara Bank branded remittances.


(Banking & Finance)

and Market Risk
Management
Unit 6
Page |1
Introduction
“NEIPL”.

Page |2
Unit 6
 Types of Non-Resident Accounts, features and operational guidelines.
 NRO, NRE and FCNR accounts- opening-operations-benefits.
Introduction
An important part of foreign exchange remittance that comes into the country is through
Non Resident Indians. The different investment options available to NRIs are discussed in
this unit with special reference to ONR, NRE and FCNR accounts.
Non-Resident Indian (NRI)

Banks in India are expected to accept deposit from `Persons Resident Outside India’ only
in the manner prescribed under FEMA and rules and regulations under this Act.
PERSON as defined in FEMA

1. An individual.
2. HUF.
3. Firms.
4. Company.
5. Other artificial (Legal) persons and any agency/office/branch controlled by such
person.
Further, FEMA defines a person resident in India and states that a person who is not a
resident is a person resident outside India. However, all persons resident outside India are
not called Non Resident Indians. A person resident outside India can be considered a Non-
Resident Indian (NRI) only if he/she is either a citizen of India or a person of Indian origin
(PIO).
In other words, if an Indian national becomes a non-resident he/she will be called an NRI.
Similarly, a foreign national who can be classified as a PIO can be called an NRI.
Therefore, Non-Resident Indians can be defined as-

1. A person of Indian Nationality or origin, who stays abroad for employment or for
carrying on business or vocation or for such other purposes which indicate an indefinite
stay abroad.
2. However, a Government official who is posted abroad to work in an Indian Mission, or

IMF is not an NRI but a student who went abroad for studies is now considered as a
NRI even though it is known that the student has gone abroad not for an indefinite stay
but for a specific stay i.e. for studies.

Page |3
3. A foreign citizen who is not a citizen of Pakistan or Bangladesh is said to be an PIO

provided he/ she at any point of time held an Indian passport or he/she or any of his
parents or even grandparents were a citizen of India.
4. A foreign citizen who marries an Indian, he or she will be considered as an PIO for the
purpose of opening an account or for investment purposes or for acquiring any property
provided the investment is in joint name.
Key features of a Non-Resident Indian-

1. Indian nationality or origin, who resides abroad for business or vocation or
employment and the period of his stay is indefinite.
2. A person is of Indian origin if he has an Indian passport, or he/she or any of his/her
parents or grand-parents were a citizen of India.
3. However a government employee posted to Indian Mission or deputed to World Bank,
IMF etc. are not NRIs because their stay abroad is not uncertain. Similarly, a tourist
who goes abroad for holidaying, does not acquire the status of a NRI.
4. One exception GOI made is that if a student goes abroad for studies, he/she will be
treated as a NRI even though it is known that he/she is not going abroad for uncertain
period.
5. A spouse, who is a foreign citizen, of an Indian citizen or a person of Indian origin is
treated as a person of Indian origin [PIO] for the purpose of opening of NRI account
and other investments in India provided such accounts and investments are in joint
names.
6. Besides individuals, Overseas Corporate Bodies [OCBs] i.e. overseas firms, trusts and
companies, predominantly owned by NRIs are called OCBs. The level of ownership of
NRIs should not be less than 60%. However, with effect from 19.09.2003, OCBs are
not permitted to invest hence are not eligible to open accounts which an NRI is
permitted to open.
Deposit Accounts in the Name of Non-Resident Indians

NRIs earn foreign currency at the place of their vocation/business. They remit money to
their motherland for the purpose of savings/ investments and or maintenance of their
families. This remittance of foreign currency helps the country in maintaining balance of
payment position, hence to attract more and more foreign currency, the GOI through the
RBI has provided NRIs with various attractive schemes like opening of specialised bank
accounts and investment opportunities with many incentives.
The different type of accounts that an NRI can open are-

1. Non-resident (Ordinary) Rupee Account (NRO).
2. Non-Resident (External) Rupee Account (NRE).
3. Foreign Currency (Non-Resident) Account (Banks) – FCNR (B).
In the above categories an NRO account can be opened by any person resident outside

Page |4
India whether he is NRI or not whereas NRE and FCNR (B) accounts can be opened only
by NRI`s.
Each of the above mentioned accounts will be discussed in detail in this unit.
Non-Resident Ordinary Rupee Account (NRO)

The NRO account is normally opened for collecting the funds from local bonafide
transactions like rent, maturity proceeds of LIC policy, UTI, Mutual Funds or such other
transactions.
Eligibility
a) Any person/ entity resident outside India (other than of Bangladesh/ Pakistani
nationality) may open NRO account for the purpose of putting through bonafide
transactions denominated in Indian Rupees, not involving any violations of the
provisions of FEMA 1999 and rules and regulations made there-under.
b) When a person resident in India leaves India for a country (other than Nepal and
Bhutan) for taking up employment or for carrying on business or vocation outside India
or for any other purpose indicating his stay outside India for an uncertain period, his
existing account should be designated as an NRO account. (In the same way, if an
Indian citizen returns to India to take up vocation/ employment or for any other
purposes, indicating his intention to stay in India for uncertain period, then his existing
NRO account should be designated as Savings Bank account).
c) The account may be held jointly with residents and/or with non-residents.
d) Opening of accounts by citizens of Bangladesh/ Pakistan requires prior approval of the
RBI.
e) Nomination facility is available.
Foreign nationals of Non-Indian origin on a visit to India

NRO accounts can be opened by a foreign national of non-Indian origin visiting India (like
tourists) with funds remitted from outside India through banking channels or by sale of
foreign exchange brought by him to India. Such NRO account can be freely debited for
local payments.
Such accounts can be closed and the balance in the account can be converted into foreign
exchange at the time of closure of the account without any reference to RBI provided the
account was not continued for more than six months and there was no credit of local funds
(except interest) to the account. If the account was continued for more than six months RBI
permission is required for repatriation.
Types of Accounts Permitted to be opened

NRO accounts can be opened in the form of savings, current, RD or term deposits as the
case may be.

Page |5
Permitted Transactions
When opening a NRO account, the account holder should furnish an undertaking that in
cases of debits to the account for the purpose of investment in India and credits
representing sale proceeds of investments, he/ she will ensure that such investments/
disinvestments will be in accordance with the regulations made by the RBI.
Besides this, the account holder should give an undertaking to the effect-
a) That he shall not make available to any person resident in India, foreign currency
against reimbursement in rupees or any other manner in India.
b) The debits and credits raised in his account representing investments made or sold shall
be covered by the general or special permission as the case may be obtained from the
authorities concerned and held by him/her.
Permitted Credits
a) Proceeds of remittance from outside India through normal banking channels received in
foreign currency which is freely convertible.
b) Any foreign currency which is freely convertible, tendered by the accountholder during
his temporary visit to India. Foreign currency exceeding USD 5000 should be
supported by currency declaration form.
c) Transfer from rupee accounts of non-resident banks.
d) Legitimate dues of the accountholder in India. This includes current income like rent,
dividend, pension, interest etc. as also sale proceeds of assets including immovable
property acquired out of rupee/foreign currency funds or by way of inheritance/legacy.
e) Transfer from another NRO account.
Permitted Payments
a) All local payments in rupees including payment for investment in India subject to
compliance with the relevant regulations by the RBI.
b) Remittance outside India of current income like rent, pension, dividend, interest etc. of
the account holder in India after payment of applicable income tax.
c) Remittance up to USD 1 million per calendar year, out of NRO accounts of NRI/PIO
for all bonafide purposes to the satisfaction of the AD.
d) Any other transaction covered by general or specific permission of RBI
Remittance of Sale Proceeds of Assets

a) NRIs/PIOs may remit amount not exceeding USD 1 million per calendar year, out of
balances held in NRO account representing sale proceeds of assets (a) acquired in India
out of rupee/ foreign currency funds or (b) by way of inheritance/legacy or settlement
from a person who was resident in India.
b) A citizen of a foreign state not being a citizen of Pakistan, Bangladesh, Nepal or
Bhutan who;
 has retired from employment in India, or
 has inherited assets from a person who was resident in India, or
 is a widow resident outside India who has inherited assets of her deceased husband

Page |6
who was an Indian citizen resident in India may remit an amount up to USD 1
million per calendar year.
c) The facility of remittance of sale proceeds of immovable property is not available to a
citizen of Pakistan, Bangladesh, Sri Lanka, China, Afghanistan, Iran, Nepal and
Bhutan. The facility of remittance of other financial assets is not available to citizens of
Pakistan, Bangladesh, Nepal and Bhutan.
Other Permitted Transactions

1. Credits pertaining to current income can be credited to NRE account of the holder,
provided the Bank maintaining the account is satisfied that the income tax thereon has
been deducted/paid/provided for. A certificate from a qualified Chartered Accountant
in this regard may be called for and held on records.
2. In the case of an NRI who has no taxable income in India, the Bank may permit credit
to NRE account, provided a declaration to that effect is obtained in duplicate by the
bank from the NRO account holder and held on records for future use by ITO if
required.
Loans/ Overdraft
Loans or overdrafts in a NRO account may be permitted to the extent of ₹ 50, 000/- by
authorised dealers against the security of the F.D. or interest earned thereon. In all other
cases, prior approval of RBI may be obtained by submitting application in Form LOV4.
A loan or overdraft facility already granted to a resident who subsequently became non-
resident may be continued for a period of one year from the date of becoming a non-
resident. However, the loan may be closed by remitting money from abroad or by debit to
his existing account in India.
Temporary overdraft maybe permitted in the NRO account to the extent of ₹ 1,000/-
subject to the condition that the overdraft will be cleared within two weeks including
interest thereon from remittances made from abroad or from transfer from his existing
NRE account maintained with any bank in India.
Non-Resident External Rupee Account (NRE)

As per NRE Accounts Rules, 1970, account opened by a Non –Resident with a bank in
India is designated as NRE Account. NRE account may be opened as savings account/
current account or term deposits as per the requirements of the NRI.
Key aspects
1. An NRE account may be opened provided he/she is a person resident outside India or a
person of Indian origin, as defined under FEMA, and is presently residing abroad and
the funds meant for credit for the said account is in freely convertible currency
emanated from abroad.

Page |7
2. NRE Account can also be opened during the temporary visit of the non-resident to
India and the initial deposits for the opening of the account should be by tendering
foreign currency notes/travellers cheques duly supported by currency declaration form
[CDF] wherever required issued by the Customs at the Port of entry i.e. at the time of
arrival in India.
3. NRE account can also be opened by transferring money from another NRE account or
by converting FCNR account into NRE account. Interest accruing on the funds held in
the account can also be used for opening of an NRE account.
4. While opening the account, the A.D. should obtain a declaration from the NRI that as
soon as he returns to India for good he shall intimate this fact to the A.D. in writing.
5. NRE account can be opened as running account in the form of savings bank account
and current account and fixed term account in the form of recurring deposit account or
term deposit with a minimum period of one year and maximum period of 5 years for
FCNR deposit and 10 years for rupee deposits.
6. NRE accounts can also be opened in joint names of two or more non-resident
individuals who are persons of Indian origin or nationality. Joint account with a
resident in India is permitted with mode of operation Former or Survivor only.
There are restrictions for debits and credits to NRE accounts.

Permitted credits in the NRE account-
a. Foreign Currency bank notes tendered by the account holder him/herself during his/her
temporary visit to India.
b. Travellers’ cheques/ bank draft drawn and payable in any freely convertible currency.
c. Remittances to India from any part of the world in any freely convertible currency.
d. Cheques drawn by NRE him/ herself on his/her account maintained abroad.
e. Transfer of any NRE/FCNR account or from any NRE/ FCNR account.
f. Any other remittances received under general permission or specific permission
granted by RBI.
g. Interest on Government securities and dividends on units of mutual funds as well as
maturity proceeds of securities/ units provided the securities/ units were purchased by
debit to the existing NRE/ FCNR accounts.
Permitted debits in the NRE account-

1. Local payments/ disbursements.
2. Remittances outside India.
3. Investment in Equity/ Securities etc.
4. Transfer to any bank or other NRI accounts.

Page |8
Other aspects
1. Residents can operate the account on the basis of a power of attorney issued by the
account holder. However, the POA holder has no right to remit the funds abroad or
close the account.
2. Nomination facility is available. A local resident can also be nominated.
3. Entire interest income earned on the balances is fully exempted from income tax, gift
tax and wealth tax.
4. Temporary overdraft for two weeks is available up to an amount of ₹ 50,000/-. The
overdrawn amount should be replenished through fresh remittances from abroad or
from any NRE/FCNR account.
5. Principal + Interest earned is allowed to be repatriated to any part of the world in free
foreign exchange without permission from RBI and without restrictions on amount or
without any type of taxes i.e. free of income tax on the interest earned.
6. A separate cheque book with notation “NRE” printed in red bold letters on the face of
each cheque leaf and made available to all NRE accountholders.
7. In NRE SB account, no lien is permitted to be marked on the balances held.
It may be noted that since NRE accounts whether SB/current/RD or term deposits are
opened and maintained in Indian rupees, they are subject to exchange fluctuation and the
exchange loss if any is borne by the account holder, except in the case of FCNR (B)
account where the account is opened and maintained in foreign currency, the exchange
fluctuation is borne by the banks concerned.
As on date, the rate of interest paid on NRE Savings Bank account as also term deposits
scheme, is the same as that paid on domestic deposits and the entire interest amount paid is
free of income tax.
Repatriation from NRO account:

$1,000,000.00 subject to payment of I.Tax in India.
1. TDS applicable for interest earned: As advised from time to time.
2. No ceiling for TOD but as per delegated powers (our bank `.5000).
3. Foreign Tourists visiting India can open NRO for maximum 6 months period
4. Senior Citizens/Staff/ex-staff/Ex-staff Senior Citizen is not eligible for special rates under
NRO deposits.
5. Cir.216/2014: TDS will be deducted & return will be submitted centrally under single TAN
(BLRC12833C) at lesser rate if our NRI customer is residing abroad on countries covered
by Double Taxation Avoidance Agreement (DTAA).Tax Residency Certificate, Request
Letter, Form 10F & Copy of PAN to be submitted by customer.
6. 15G/15H cannot be accepted from an NRI.
7. Fortnightly & Quarterly statement regarding total number and amount remitted from NRO
account to be submitted by designated branches/Foreign department to their circle offices
for onward submission to RBI through NRI & MI (Forex) Division, Integrated Treasury
Wing, and Mumbai (Cir 117/2013).

Page |9
The distinction between a NRO and NRE account-

1. A NRE account is governed by the NRE Account Rule of 1970 and is opened with
funds remitted from abroad through normal banking channel in freely convertible
foreign currency, while NRO account can be opened by remittances made from within
the country or from remittances received from abroad.
2. The interest income derived in a NRE account is exempt from income tax whereas any
income derived in a NRO account is subject to normal income tax laws. Gift made
from out of the funds in NRE account to a resident is free from Gift tax.
3. Balance available in NRE account can be repatriated abroad without the permission of
RBI, whereas funds available in NRO account can be repatriated only with PRIOR
permission from RBI.
Foreign Currency [Non-Resident] Account (Banks) – FCNR (B) Accounts

A Foreign Currency Non Resident Account-B is opened and maintained in foreign
currency. However, at present, only term deposits are permitted to be opened under this
scheme. However, in this fixed deposit scheme there are certain conditions and all these
conditions are required to be fulfilled. The conditions are :
1. The account will not only be opened in foreign currency, but in specified designated
currency only.
2. The foreign currencies permitted are US Dollars, Euro, Pounds Sterling, Japanese Yen,
Canadian Dollars and Australian Dollars. However, RBI has given blanket permission
to all the A.D.s that they are free to open FCNR account in the currency of their choice
provided the Bank concerned are maintaining position in their books in respect of the
said currency.
3. Only term deposits can be opened ranging from a minimum of one year to maximum of
5 years.
4. Joint accounts are permitted.
Other aspects
1. The exchange risk is borne by the bank concerned.
2. Repatriation of principal amount and interest is permitted without seeking permission
from RBI.
3. The interest on the deposits will accrue on 360 days basis and be paid twice a year.
4. Nomination facility is available.
5. Income earned is fully exempted from income tax.
6. No operation by way of POA is permitted.
7. Forward cover is available to hedge the balance held in the account.
8. Account may be opened for a minimum period of one year to a maximum period of 5
years. However, premature withdrawal before one year will attract swap charges and
also no interest will be payable.

P a g e | 10
9. If opened with Foreign Currency Notes of above USD 10,000, Requires MIPD
permission along with furnishing following documents- The deposit support extended
by NRI, Period of deposit, confirmation regarding CDF etc.
10. If closed before 1 year , No interest (and Service charges @1.25% for those opened
with Foreign Currency Notes only)
11. If closed after 1 year, 1% penal cut on applicable interest.
12. At the request of depositor, banks to be allowed to permit remittance of the maturity
proceeds of FCNR (B) deposits to third parties outside India, provided bank is satisfied
about the bonafides of the transaction.
13. Penalty for before maturity closure of FCNR (B) deposit for reinvestment in FCNR (B)
deposit in other permitted currency is 1%
14. The balance outstanding in FCNR accounts should not be transferred as unclaimed
deposit. (Cir.310/2007)
15. In case FCNR deposits are opened out of the proceeds of cheques sent under Secured
Collection Service, our branches should absorb the charges. However, branches should
note to recover such charges, if the FCNR deposit is closed before the completion of 12
months. Fact of waiver of charges should be noted boldly on the face of such FCNR
deposit receipts. (IO Cir.57/2010)
16. NRIs are allowed to invest in the Indian Depository Receipts - IDRs out of funds held
in their NRE / FCNR (B) account, maintained with an Authorised Dealer / Authorised
bank. (Cir.IO/49/2009)
17. Loan against security of NRE/FCNR(B) term deposits can be granted to depositors or
third parties without monetary ceiling subject to margin requirement, delegation of
powers, execution of documents, interest rates, noting of lien, purpose of loan,
repayment etc. Premature withdrawal of deposit will not be permitted during the
pendency of loan (IO/130/2012).
It can be concluded that the kind of importance the GOI attaches to the Non-Resident
segment in the Indian Banking. The kind of bank accounts, products for investment both on
repatriable and non-repatriable basis made available to NRI account holders speaks
volumes of the kind of importance this segment enjoys in the Indian economy. Key aspects
related to opening of and operations in the above accounts have been discussed in the
module on Introduction to Banking, Deposits & Remittances in the first Term.
Unit summary
 Different Types of Non-Resident Accounts, features and operational guidelines.
 NRO, NRE and FCNR accounts- opening-operations-benefits.


(Banking & Finance)

and Market Risk
Management
Unit 7
Page |1
Introduction
“NEIPL”.

Page |2
Unit 7
 Forward Contracts-Booking, Cancellation and Extension.
Introduction
A Foreign Exchange market is a market in which foreign currencies are bought and sold. It
is an over-the-counter [OTC] market with Authorised Dealers licensed by RBI operating in
a place well connected through telecommunication apparatus forming a hub. Foreign
Exchange market is one of the largest financial markets in the world with a daily turnover
of approx. USD 5.35 Trillion. It is called a 24 hour market because at any point of time one
or the other country is open for trading in foreign currencies i.e. when Australia closes
India opens, when India is having lunch London opens and when India closes, USA opens.
Thus, at any point of time one or the other market world over operates and you get a quote.
Participants in a foreign exchange market are corporates, commercial banks, exchange

brokers and the central bank of the country including hedgers, speculators and arbitrageurs.
Transactions in inter-bank market can be-

a) Spot transactions i.e. settled in two working days.
b) Forward transaction settled at a specified future date – one month to twelve months
c) Swap transactions – involving simultaneous purchase and sale of currency for different
periods, and;
d) Non-deliverable forwards – here only the difference in prices is settled on the due date
In this chapter we will discuss Forward contracts and aspects such as Booking,
Cancellation and Extension of Forward contracts.
Forward contracts
A Forward Contract is an arrangement whereby an agreed amount of foreign currency is
bought or sold for delivery on a specified future date, at a pre-determined rate of exchange.
The parties to the contract may be a bank and a customer or the contract can be between
two banks also.
A Forward Contract is an Over The Counter [OTC] product and is available any time
during working hours and can be availed only with any Authorised dealer authorised by
RBI to deal in foreign exchange transactions.
The Reserve Bank of India has defined forward contract as “A foreign exchange forward is
an over-the-counter contract which a purchaser agrees to buy from the seller, and the seller
agrees to sell to the buyer, a specified amount of a specified currency on a specified future
date – beyond the spot settlement date – at a known price denominated in another currency

Page |3
(known as the forward price) that is specified at the time of entering into thecontract”
Following are the salient features of a foreign currency forward contract-

1. Exchange Rate: A Forward Contract is an arrangement to fix beforehand the exchange
rate for a currency to be exchanged at a future date. The rate fixed on the date of
executing a contract is applied on the date of delivery, when the transaction is to be
executed, irrespective of the spot rate at that point of time.
2. Parties involved: The transactions may be between two banks or between bank and its
customer.
3. Execution: The execution is by physical delivery of the contracted amount i.e. the
customer should pay in Indian Rupees and the bank will deliver foreign currency
equivalent or the customer must pay in foreign currency and the bank will credit his
account in Indian rupees. The settlement is by actual delivery.
4. OTC Product: Product is readily available on demand at any foreign exchange branch
of a bank only and not traded anywhere else.
5. Counter party risk: Since the product is not traded anywhere it carries a counterparty
risk i.e. the possibility that one of the parties may default on the due date while the
other has or is willing to execute.
6. Period: Generally available for a period of twelve months at a higher cost.
7. Perfect Cover: Since the cover is available for the exact amount, exact date and is
readily available at the counter without any hassle it is a perfect cover for any foreign
exchange customers.
Other salient features of the Contract is as under-

1. Delivery of the foreign currency must be given or taken as per contract terms on the
expiry date of the contract otherwise the contract will be cancelled and the difference
between spot rate and forward rate will be recovered in case of loss and credited to
customer`s account in case of profit.
2. Delivery can be done within a month before the expiry date, provided a request is made
by the customer to the Bank. This is known as Forward Option. However in such a
situation, the Bank would quote forward premium or discount as the case may be
applicable from either start date or end date of the option period, whichever is in favour
of the bank.
3. Forward Rate in simple terms is nothing but the difference in rate of interest of the two
currencies in question.
4. The Forward Rate is at a discount or at a premium to the spot rate. The currency
carrying higher rate of interest will always be at a discount.
5. In case of free currencies forward premium or discount is exactly equal to the
difference between interest rates of the two currencies. Here the word “free” denotes
convertibility. For e.g. Rupee is still not fully convertible on capital account
transactions. The forward exchange rate of USD/INR is therefore affected by supply
and demand for forward dollars
6. Forward contract is an ideal instrument of hedging to achieve zero risk as the

Page |4
contracted rate fixes the value of dollars at a future date, irrespective of movement in
the market.
7. One most important thing to be noted in forward contract is the holder of the forward
contract is deprived of the benefit of spot rate should the spot rate at the time of
delivery be less than the forward contracted rate – therefore, to that extent forward
contract is to the disadvantage of the customer.
Thus, Forward Cover is one of the most sought after and a traditional method by which
exporters and importers cover their exchange risk, but at the same time it takes away the
opportunity to make undue profits from favourable movements in exchange rates.
Forward contracts impose an obligation on the parties to the agreement that irrespective of
the spot rate prevailing on the due date of the contract, the agreed contract will be executed
on the due date and at the contracted rate. However, if one wants to take advantage of the
better rate, he/she is free to cancel the contract as per FEDAI norms and compensate the
bank by making good the cancellation charges. Normally, the cancellation charges are
greater than the benefit obtained in the spot market.
Besides this, FEMA-1999 also governs foreign exchange contracts in India. As per
schedule 1 to the Regulations, a person resident in India may enter into a forward contract
with an A.D. to cover his exposure in respect of transactions for which sale and/or
purchase of foreign exchange is permitted under FEMA subject to other terms and
conditions.
FEMA 1999 has framed overall guidelines for the functioning of the Foreign exchange
Department. Similarly FEDAI and RBI have framed rules for the specific products too.
While we have seen the FEDAI guidelines for Forward Contract, the guidelines issued by
the Reserve Bank of India are:
Person resident in India can avail of this over the counter product from any A.D. in India
under following categories-
1. To cover actual committed exposure by providing documentary evidence to the bank
for the existence of the exposure. For e.g. the importer has to show the Performa
invoice to the banker of having committed an exposure.
2. To cover probable exposure based on past performance without the need to provide
documentary evidence available to exporters and importers.
3. Special dispensation which enables small and medium enterprises and resident
individuals to cover their exposure without providing documentary evidence.
Each of the above categories has been explained in detail below.

A. Committed Exposure
Persons resident in India, are permitted to cover their exchange risk in, transactions for
which sale and/ or purchase of foreign exchange is permitted as per Law i.e. FEMA.

Page |5
1. The market value of overseas direct investment [in equity and loan]-
a) These contracts may be cancelled or rolled over on due dates. Rebooking is
permitted only to the extent of 50% of the cancelled contracts.
b) If a cover becomes open partially or fully owning to contraction of the market value
of the ODI, the forward cover may be allowed to continue until maturity, if the
customer so desires. Rollovers on due date shall be permitted up to the extent of the
market value as on that date.
2. To cover exchange rate risk of transactions denominated in foreign currency but settled
in Indian rupee, including covering the economic exposure of importers in respect of
customs duty payable on imports.
Procedure
1. Banks should satisfy themselves through verification of documentary evidence about
the genuineness of the underlying exposure, irrespective of the transaction whether it is
a current or a capital account. Full particulars should be endorsed on the original
documents and authenticated by an authorised official. In case original documents are
not available then a certified photocopy of the original documents should be obtained
and held on records. The A.D. should also obtain an undertaking from the customer and
also quarterly certificates from their statutory auditors.
2. If for some reasons, original documents could not be made available at the time of
booking the contract, the A.D. may permit a time of 15 days for submission. However,
even after 15 days if the customer is not in a position to submit original documents, the
A.D. may cancel the contract and if there is any gain the AD has made, it should be
retained by the AD.
3. In the event of non-submission of the original documents by the customer within 15

days on more than three occasions in a financial year, booking of forward contract may
be allowed only on production of original documents.
4. The maturity of the hedge should not exceed the maturity of the underlying transaction.
The currency of the hedge and tenor, subject to the above restrictions are left to the
customer. Where the currency of hedge is different from the currency of the underlying
exposure, the risk management policy of the corporate approved by the board of the
directors, should permit such type of hedging.
5. Where the exact amount of the underlying transaction is not ascertainable, the contract
may be booked on the basis of reasonable estimates. However, the estimates should be
periodically reviewed.
6. An undertaking should be obtained from the customer furnishing that the forward
contract for the same contract has not been booked with any other A.D. in India. In
case more than one bank is involved, and the exposure covered is taken delivery of in

Page |6
part, the other bank should be kept informed about the details.
7. Quarterly certificates from the statutory auditors of the users should be furnished that
the contracts outstanding at any point of time with all banks during the quarter did not
exceed the value of the underlying exposure.
8. Foreign Currency loans/bonds will be eligible for cover only after final approval is
accorded by the RBI for which such approval is necessary or loan registration number
is allotted by RBI.
9. GDRs/ADRs are eligible for cover only after the issue price has been finalised.
10. Balances in EEFC account sold in forward market shall remain earmarked for delivery
but such contracts will not be cancelled. They are however, eligible for rollover on
maturity of the contract.
11. All non-deliverable forward contracts can be rebooked on cancellation. Forward

contracts involving the Rupee as one of the currencies booked by residents to hedge
current account transactions, regardless of the tenor, and to hedge capital account
transactions, falling due within one year, may be allowed to be cancelled and rebooked.
This relaxation of cancellation and rebooking will not be available to forward contracts
booked on past performance basis without documents as also forward contracts booked
to hedge transaction denominated in foreign currency but settled in INR.
12. The facility of cancellation and rebooking is not permitted for forward contracts
involving Rupee as one of the currencies, booked by residents to hedge capital account
transactions for tenor greater than one year. These forward contracts if cancelled with
one Bank can be rebooked with another Bank, subject to following conditions:
a) The switch is warranted by competitive rates on offer, termination of banking
relationship with the bank with whom the contract was originally booked;
b) The cancellation and rebooking are done simultaneously on the maturity date of the
contract; and
c) The responsibility of ensuring that the original contract has been cancelled rests
with the bank who undertakes rebooking of the contract.
13. The facility of rebooking should not be permitted unless the corporate has submitted
the exposure information as prescribed.
14. Substitution of contracts for hedging trade transactions may be permitted by a Bank on
being satisfied with the circumstances under which such substitution has become
necessary. The Bank may also verify the amount and tenor of the underlying
substituted.

Page |7
B. Probable Exposure based on Past Performance

Importers and Exporters of goods and services can book forward contracts to cover the
currency risk on the basis of a declaration of an exposure and based on past
performance up to the average of the previous three financial years [April to March]
actual import/export turnover or the previous year’s actual import/export turnover
whichever is higher. Probable exposure based on past performance can be hedged only
in respect old trades in merchandise goods and services.
Procedure
1. The contracts booked during the current financial year [April-March] and the
outstanding contracts at any point of time should not exceed the eligible limit i.e.
the average of the previous three financial years’ actual import/export turnover or
the previous years’ actual import/export turnover whichever is higher.
2. Contracts booked in excess of 75 percent of the eligible limit will be on deliverable
basis and cannot be cancelled.
3. The limit shall be computed separately for import/export transactions.
4. Higher limits will be permitted on a case-by-case basis on application to the
Foreign Exchange Department, Central Office, RBI. The additional limits if
sanctioned shall be on a deliverable basis.
5. Any contract booked without producing documentary evidence will be marked off
against this limit. These contracts once cancelled, are not eligible to be rebooked.
Rollover is also not permitted.
6. Banks should permit their clients to use the past performance facility only after
satisfying themselves that the following conditions are complied with-
a) An undertaking may be taken from the customer that supporting documentary
evidence will be produced before the maturity of all the contracts booked.
b) Importers and exporters should furnish a quarterly declaration to the bank’s
duly certified Auditor, regarding amounts booked with other banks under this
facility.
c) For an exporter customer to be eligible for this facility, the aggregate of overdue
bills shall not exceed 10 percent of the turnover.
d) Aggregate outstanding contracts in excess of 50 percent of the eligible limit
may be permitted by the Bank on being satisfied about the genuine
requirements of their customers after examination of the following documents.
e) A certificate from the statutory auditor of the customer that all guidelines have
been adhered to while utilising this facility.
f) A certificate of import/export turnover of the customer during the past three
years duly certified by their statutory auditor.
7. The past performance limits once utilised are not to be reinstated either on
cancellation or on maturity of the contracts.
8. Banks must arrive at the past performance limits at the beginning of every financial
year. The drawing up of the audited figures (previous year) may require some time
at the commencement of the financial year. However, if the statements are not

Page |8
submitted within three months from the last date of the financial year, the facility
should not be provided until submission of the audited figures.
C. Special Dispensation
1. Small and Medium Enterprises (SMEs): Small and Medium Enterprises are the
backbone of the economy as they generate huge potentiality for jobs for the local
youths as also they are self-employed. They may or may not have direct/in-direct
exposure to foreign risk. Hence, to provide them with a push SMEs are permitted to
book/cancel/rebook/rollover forward contracts without production of underlying
documents subject to following conditions:
a) Such contracts may be booked through Banks with whom the SMEs have credit
facilities and the total forward contracts booked should be in alignment with the
credit facilities availed by them for their foreign exchange requirements or their
working capital requirements or capital expenditure. Banks should carry out due
diligence regarding user appropriateness and suitability of the forward contracts
to the SME customers.
b) The SMEs availing this facility should furnish a declaration to the Bank,
regarding the amounts of forward contracts already booked, if any, with other
banks under this facility.
2. Resident Individuals: Resident individuals can book forward contracts to hedge

their foreign exchange exposures arising out of actual or anticipated remittances,
both inward and outward up to a limit of USD 100,000.00 based on self-
declaration.
a) The contracts booked under this facility would normally be on a deliverable
basis. However, in case of mismatches in cash flows or other exigencies, the
contract booked under this facility may be allowed to be cancelled and
rebooked. The notional value of the outstanding contracts should not exceed
USD 100,000 at any point of time.
b) The contracts may be permitted to be booked up to tenor of one year only.
c) Such contracts may be booked through banks with whom the resident individual
has banking relationship, on the basis of an application-cum-declaration in the
format prescribed
d) Banks should carry out due diligence regarding user appropriateness and
suitability of the forward contracts to individual customers as also whether they
understand the nature of risk inherent in booking of forward contracts.
To keep a check and to monitor this vital tool in the hands of the A.D. and the customers,
the forward cover is subject to rules framed by the Foreign Exchange Dealers Association
of India [FEDAI] and every customer and A.D are required to strictly adhere to the Rules.
Out of the many rules and regulations enacted, Rule 7 of the FEDAI relate to Forward
Contract. Key aspects of the same are discussed below.

Page |9
A. Date of Delivery: According to Rule 7 of FEDAI, “Forward Contract” is deliverable at

a future date, duration of the contract being computed from the spot value date of the
transaction. Thus if a 2 months forward contract is booked on say 10th of March, the
period of two months should commence from 10th March and the forward contract will
fall due for delivery of foreign currency in 10th of May.
Date of Delivery of forward contracts will be-

1. In case of bills/ documents negotiated under LC, purchased or discounted, date of
negotiation/ purchase/ discount and payment of rupees to the customer;
2. In case of bills/ documents sent for collection, date of payment of rupees to the
customer upon realisation of the foreign currency;
3. In case of retirement/ crystallisation of import bills/ documents, the date of
retirement of crystallisation of liability, whichever is earlier.
B. Fixed and Option of Forward Contracts: The forward contract under which the
delivery of foreign exchange should take place on a specified future date is known as
“Fixed Forward Contract”. For e.g. if on 15th April a customer enters into a three month
contract with an A.D. to purchase USD 10,000, it means the customer would be
receiving the import bill by 12th July. He cannot ask for foreign currency before 12th
July or after 15th July. Therefore it can be construed that forward cover is a tool by
which the importer tries to cover his exchange risk. However, the purpose will not be
served if he is not able to take delivery of the committed foreign exchange on the due
date i.e. before 15th July.
But in the practical world it is not possible for an importer sitting in India to predict
exactly when will his shipment take place and when will his bill reach his A.D in India
and when will his A.D register the bill in the A.D.s records and present him for
payment.
After considering all the above factors and with a view to eliminate the practical
difficulties customer’s encounter in arriving at the exact date by which he will be able
to take delivery of the committed foreign currency, the customer is given a choice of
obtaining the delivery of the foreign currency during a given period of time.
An arrangement whereby the customer can sell or buy from the A.D. foreign currency
on any day during a given period of time at a predetermined rate of exchange is known
as “Option Forward Contract”
As per Rule 7 of the FEDAI Option Forward Contract means-

1. The option period of the delivery should not exceed one month. For e.g. 1 st means
any day between the 1st and last day of the month.
2. As between a bank and a customer, the option is that of the customer. So the bank
cannot force the customer to deliver or take delivery of foreign exchange on any

P a g e | 10
specific date. It is up to the customer to choose any date within the option period.
Suppose the given period is one month i.e. within one month he should take delivery or
give delivery of the foreign currency. For e.g. a forward contract is booked say on 1 st
October for 3 months. Then he can take delivery on any day in the month of December.
It has been seen herein above, FEMA 1999 has framed over all guidelines for the
functioning of the foreign exchange department. Similarly, FEDAI and RBI has framed
rules for the specific products too. Given below are guidelines issued by the Reserve
Bank of India for forward contracts.
Person resident in India can avail of this over the counter product from any A.D in
India under following categories-
1. To cover actual committed exposure by providing documentary evidence to the
bank for the existence of the exposure. For e.g. the importer has to show the
Performa invoice to the banker of having committed an exposure.
2. To cover probable exposure based on past performance without the need to provide
documentary evidence available to exporters and importers.
3. Special dispensation which enables small and medium enterprises and resident
individuals to cover their exposure without providing documentary evidence.
Booking Forward contracts

Every A.D. has its own procedure for booking and utilisation of forward contract, which is
enumerated hereunder-
1. The first step gets initiated with the customer asking for the exchange rate. Before
quoting the rate to the customer, the bank official should seek complete details of the
contract viz.,
a) Currency - which currency, Dollar - which Dollar - USD, Singapore Dollar,
Australian Dollar or Canadian Dollar? Please clarify with the customer properly
because for every currency the rate is different.
b) The likely date of delivery of the currency – Whether a sight bill or having a tenor –
if having tenor – what is the tenor 30/60/120/180??? – A sight bill means payment
on presentation i.e. only notional transit period is allowed as grace and the bill is
required to be paid within that period or else it will be treated as overdue. In case
the customer says that the bill is on tenor basis then please clarify the period of
tenor because the tenor may range from 30 days to maximum of 180 days.
c) The nature and tenor of the instrument – Whether the bill is under LC or Confirmed
order. The calculation of due date is from shipment date or otherwise.
2. All these information is vital from the point of view of calculating the forward rate.
Any error on this information, the rate will go wrong and there could be exchange loss
which the customer will have to bear should there be any wrong information.

P a g e | 11
3. Usually forward rates are not quoted by the branches directly but in consultation with
the Dealing Room i.e. through the Dealers. The branch official after ascertaining all the
vital data on the bill should feed the information in the System and take up the matter
with the Dealing Room for rate.
4. After getting the rate, the bank official should confirm it with the customer and if the
customer accepts the rate, he is required to submit an application in the format
prescribed along with documentary evidence showing the purchase/ sale contract he
holds from his customers.
5. After scrutiny of the application, the bank officials prepare the Forward Exchange
Contract either purchase/ sale as the case be. If the transaction is an export transaction,
it is purchase for the bank and if it is import transaction it is a sale for the bank. This
again should be kept in mind at the time of furnishing rate to the customer.
6. While preparing the contract, the following points are to be noted-

a) The branch should make a note of full details of the contract in a separate register
and give a running serial number so that as and when the same comes for utilisation
the contract can be identified easily.
b) Contract must state the first and last date of delivery. It may not be sufficient if
words like one month or such other vague delivery dates are mentioned. The
delivery date of the contract should be clear and unambiguous.
c) In case more than one rate for bills with different deliveries are mentioned, the
contract must state the amount and delivery date of each separately.
d) No usance option may be stated in any contract for the purchase of bills because
under purchase the contract should be only for the notional transit period and not
any other grace period for payment of the bill.
e) The contract should be complete in all respects.
7. The number of copies of the contract to be prepared will depend upon the requirements
of the bank and also that of the customer. Sometimes a customer may ask for contract
in duplicate or for the bank one copy of the contract is required to be sent to their
central office for records in that case the number of copies to be prepared may be kept
in mind.
8. Incorporate all the details in the forward contract register based on the original
documents verified and copy held.
9. After verification of the documents, certify the photocopy under the seal and signature
of the bank official.
10. Diarise the due date of the contract and follow up the same on due date without fail.

P a g e | 12
11. Collect charges as per the schedule prescribed by the bank.
12. Round off the entry in the forward contract register upon cancellation or upon
utilisation as the case may be under proper authentication of the official concerned.
Execution of booked Forward contracts

A booked Forward contract has to be delivered on time because the time and amount of
foreign exchange to be delivered are predetermined under a forward contract and the
customer is bound to take delivery as per the agreement. So as per records there should not
be any variation in the amount as also on the delivery date. But in practice quite often than
not, there could be delay, cancellation of the order or there could be a situation of early
delivery or no delivery at all. Now normally the bank is seized of such situations and
agrees to these variations provided the customer makes good the loss if any.
From the above it is clear that a forward cover made available to a customer to cover the
risk from exchange fluctuation may end up in any one of the following ways:-
1. Delivery on due date
2. Early delivery
3. Late delivery
4. Cancellation on due date
5. Early cancellation
6. Late cancellation
7. Extension on due date
8. Early Extension
9. Late Extension
Except delivery on due date, all other situations have consequences. Some consequences
may be positive and some may be negative. It all depends upon the market on the date of
such incident.
Other aspects
Some other aspects of Forward contracts are given below.
1. Cancellation of Forward contract: The customer is at liberty to approach his bank for
cancellation of the Forward Contract for the reasons that he is not able to execute the
order or for some other reasons best known to him/her. However, he must approach the
bank a day before the maturity date so that the contract can be cancelled or extended as
per his wishes.
When a forward purchase contract is cancelled on the due date, it is presumed that the
delivery of the contract is taken but instead of utilising it for the purpose of a bill, the

P a g e | 13
bank sells it in the market at the spot rate and whatever difference between the
contracted rate and spot rate is there the same is recovered or credited to the customer
account. The entries pertaining to sale and subsequent purchase is not routed through
the customer’s account, but only the difference i.e. plus (minus) is reflected in the
customer’s account.
2. Extension on due date: When a forward contract is sought to be extended due to

situation beyond the control of the customer, the contract is cancelled and rebooked for
the new due date at the prevailing exchange rate.
3. Overdue Forward contract: There is no hard and fast rule that if a contract is booked
it cannot be cancelled. The customer has every right to utilise, cancel, extend or
rollover the forward contract booked before its due date. However, if the contract
expires then the customer has no right to extend the said contract.
FEDAI Rule 8 provides that a forward contract which remains overdue without any
instructions from the customer concerned on or before its due date, shall unilaterally on
the 15th day from the date of maturity stand automatically cancelled. The difference if
any between the contracted rate and the spot rate will be recovered/ credited to the
account of the customer.
4. Roll-Over Forward Contract: In foreign exchange there are some transactions which
go beyond 180 days. For e.g. deferred payment imports/exports, repayment of certain
foreign currency loans. For all such transactions forward cover is available, but only for
6 months. Transactions beyond six month forward are booked but then after six months
the contract is rolled over for another six months.
Thus, forward contract is a derivative which insulates the exporter involved in international
trade and in the same way it insulates all such players in the foreign exchange market be it
importer, remitter including speculator, as everybody is free to book a forward contract to
cover his or her foreign exchange transactions. In other words, a Forward Contract is an
arrangement whereby an agreed amount of foreign currency is bought or sold for delivery
on a specified future date, at a pre-determined rate of exchange. The parties to the contract
may be a bank and a customer or between two banks also.
Unit summary
 Forward contracts-Booking, Cancellation and Extension.


(Banking & Finance)

and Market Risk
Management
Unit 8
Page |1
Introduction
“NEIPL”.

Page |2
Unit 8
 Types of merchant rates and selection of rate for forex transactions.
 Facilities available for Residents: Foreign Currency accounts for Residents- Exchange
Earners Foreign Currency Accounts, Resident Foreign Currency Accounts and
Resident Foreign Currency (Domestic) accounts.
Introduction
Foreign exchange dealings of a bank with other banks are referred to as inter-bank
transactions and transactions with bank‟s customers are known as “Merchant
Transactions”. In merchant transactions the bank buys and sells foreign exchange for and
on behalf of its customers. Such transactions are generally cash/ready transactions as they
are executed/ settled on the same day.
While undertaking foreign exchange transactions on behalf of the customer it should be

kept in mind that the transaction is done from the point of view of the bank. It means that
the rate at which the transactions are done should be favourable to the bank.
Further, the terms „Purchase‟ and „Sale transactions‟ in merchant transactions refer to,
“purchase of foreign currency by bank” and “sale of foreign currency by bank”. When
the bank says that they have purchased the foreign currency they mean they acquired
foreign currency from the customer and in return they paid the customer Indian rupees and
when the Bank says that they sold the foreign currency, the Bank means, Bank gave away
foreign currency to the customer and in return Bank got the Indian rupee.
In order to buy and sell foreign currency for and on behalf of customers the bank needs to
quote a rate for the transactions i.e. whether it is a purchase transaction or whether it is a
sale transaction. The quotation to the customer is one way which is a direct quotation i.e.
for purchase of one USD, the bank‟s quote may be say ₹ 67.25and for selling foreign
currency the bank‟s quote may be say ₹ 68.00 per USD, i.e. a difference of 75 paise
between purchase and sale price. It may be noticed that the rates quoted have to be
favourable to the bank. In the above quote while bank gives ₹ 67.25 for a USD and takes ₹
68 for giving a USD.
The customer intending to purchase or sell has to specifically seek individual transactions-
wise rate, providing all the requisite details of the transaction to the Bank.
Foreign exchange rates

As discussed earlier, foreign exchange is a commodity for the dealers and therefore traded
in the inter-bank foreign exchange markets world over. In the inter-bank market, however,
the bank will accept the rate as prevailing in the market and it cannot bargain for rates.

Page |3
In the merchant transactions however, this is not the case. In merchant trades the inter-bank
rate forms the basis on which the bank quotes its merchant rate. It is therefore, known as
the base rate. When bank buys foreign exchange from its customers, the rate quoted by the
bank will be slightly lower than what it is offered in the inter-bank market since it has to
acquire foreign exchange from the market for giving it to the customer hence bank`s
margin is reduced from the inter-bank rate to quote merchant rate to the customer.
Similarly when a customer approaches a bank to purchase foreign currency to meet its
imports or outward remittances, the bank acquires foreign currency from the interbank
market and after adding its margins sells the same to the customer.
The margin is loaded over the base rate since the bank has to meet its administrative cost
and also earn some profit from each transaction. Further, the foreign currency market is
very volatile. The rates change from second to second, therefore, the quoted rates have to
keep an allowance for these fluctuations also.
Added to the above situation is the fact that the deal with the customers takes place first
and then the bank approaches the inter-bank market to sell or acquire. There is a long time
lag between the time transactions are concluded with the customers and the time the bank
approaches the inter-bank market for disposal or for acquiring currency. Further, foreign
currency can be sold or purchased in the inter-bank market only in defined lots which is
generally not less than a million dollar or equivalent.
Furthermore, the foreign currency market is a very volatile market therefore, rates in the
inter-bank market could move against the bank by the time bank approaches the market for
buying or selling foreign exchange after doing merchant transaction.
Taking all these factors into consideration the banks quote rate to the customers after
loading sufficient margin in the inter-bank rate. The Management of the bank decides the
quantum of load to be added in the inter-bank rate to arrive at merchant rate to be quoted to
the customers of the bank.
The exchange rate is quoted up to 4 decimals in multiples of 0.0025. The quotation is for
one unit of foreign currency except in the case of Japanese yen, Belgian franc, Italian lira,
Indonesian rupiah, Kenyan shilling, Spanish peseta and currencies of Asian Clearing Union
[ACU] i.e. Bangladeshi Taka, Myanmar Kyat, Iranian Riyal, Pakistan Rupee and Sri
Lankan Rupee, where the quotation is for 100 units of the foreign currency concerned.
For example quotation of rate of major currencies are-

USD 1=₹ 68.2350
GBP 1=₹ 96.3525
EUR 1=₹ 62.5000
JPY 100= ₹ 50.6075

Page |4
While computing merchant rates, calculations are generally made up to five places of
decimal and finally rounded off to the nearest multiple of 0.0025. For example, if the rate
for USD works out to ₹ 62.12446 per dollar, than it is normally rounded off to ₹ 62.1250
As per FEDAI Rule No.7the rupee equivalent amount paid to/received from a customer on
account of foreign exchange transaction should be rounded off to the nearest rupee i.e. NIL
upto 49 paise and should be rounded off to higher rupee in case of 50 to 99 paise.
In the inter-bank market there is nothing like bills rate or TT selling rate. It is straight two
way quotation which says “I buy” and “I sell”. However, same is not the case with
“merchant rates”. In merchant transactions there are different types of rates applied for
different type of transactions. In all purchase transaction, the bank acquires foreign
currency from customers and in return pays them in Indian Rupees. But all purchase
transactions are not alike. Some purchase transactions result in the bank acquiring foreign
exchange beforehand and the Indian rupee is parted with later, while in some cases there is
delay in the acquisition of foreign exchange but the Indian rupee is parted with
immediately i.e. even before the arrival of foreign currency in the account of the bank
concerned.
For example -
“A Demand Draft dated 10.02.2015 drawn by the foreign correspondent say Standard
Chartered Bank, London for GBP 1000 is presented for payment on 15.02.2015. In such a
transaction, the foreign correspondent would have credited our account on 10.02.2015 i.e.
the day DD was issued”. Hence in this case the foreign currency is received in our account
before-hand i.e. on 10.02.2015 and the Indian rupee is parted on 15.02.2015.
In another case, of a bill purchase transaction dated 02.02.2015, after the rupee equivalent
is paid to the customer on 02.02.2015, the bill is sent for collection on 05.02.2015 to the
foreign bank. The foreign bank will record it in its register and present the bill for payment
to the drawee. All this requires at least say 20/25 days. Here in this type of transaction,
though we parted with Indian rupee we received the foreign currency on 27.02.2015 i.e.
after a gap of 25 days.
From the two examples it can be seen that both transactions are “purchase” transaction as
far as the normal banking transactions are concerned. In the first case, the foreign currency
is received in advance i.e. on 10.02.2015 and then the Indian Rupee is parted with, which
was one on 15.02.2015. Whereas in the second case, the funds were parted with first i.e. on
02.02.2015, but the foreign currency was credited on 27.02.2015 in the Nostro account
upon realisation of the export bill.
Depending upon the time taken for receipt of foreign currency in the Nostro account of the
bank, two different types of buying rates are quoted by the banks in India.

Page |5
They are-
1. TT Buying Rate: This rate is applied when the currency is already credited into the
Nostro account. This rate is normally better than the Bills buying rate because the
foreign currency is already credited to Bank‟s account and then Bank is parting with
the rupee equivalent.
The following transactions are examples of the application of TT Buying rate -
a) Payment of DD/MT/TT only after the drawer bank credits the foreign currency in
our Bank‟s Nostro account.
b) Foreign Bills sent for collection realised – Whenever a foreign bill is sent for
collection, the foreign bank will credit the proceeds as and when the buyer makes
the payment. When such information is received from the foreign bank, the foreign
currency is converted by applying the TT buying rate.
c) Cancellation of foreign exchange sold earlier. For e.g. A purchaser of a DD
approaches you with a request to cancel the DD drawn and payable in USA as his
tender was not accepted by the USA govt. – In such a transactions though foreign
currency is not realised while issuing a DD we had credited the Nostro account with
the foreign currency amount equivalent to the DD hence it is considered as amount
realised only.
2. Bill Buying Rate: When an exporter exports the goods he draws a bill on his buyer
abroad and submits the same to the A.D. If such a bill is purchased at his request to
liquidate the pre-shipment finance he has availed or he requires money for payment of
his debtors, Bill Buying Rate is applied.
At the request of the exporter the A.D. purchases the bill by applying the bills buying
rate and credits the account of the exporter say on 5.2.2016 and sends the bill to the
foreign bank for collection say on 06.02.2016. The transit period starts from the day the
bill is lodged in the System. The normal transit period as per FEDAI for realisation is
fixed i.e. within 25 days. Hence the foreign currency is expected to be credited to the
A.D.s Nostro account after a period of say 20/25 days only, say on 28.02.2015.
Where the exporter‟s account is immediately credited the bank is entitled to claim
interest (for the period the Bank was out of funds) from the customer from the date of
purchase of the bill till the bill is realised that is the value date and credited to the
Nostro account of the bank with correspondent bank abroad.
The bank officials should note to recover the interest for the transit period when
crediting the exporter‟s account including for the period of usance if any upfront by
raising a separate debit comprising of the normal transit period – normally 25 days and
the usance period if any.
Normal transit period is prescribed by FEDAI for realisation of a sight export bill – the

Page |6
meaning of transit period here as per FEDAI is the average period normally involved
from the date of negotiation/purchase of the bill till the receipt of bills proceeds in the
Nostro account of the collecting bank.
As of now FEDAI has prescribed 25 days for all bills irrespective of the destination of
the bill unlike earlier period where the transit period was based on the destination of the
bill taking into consideration the distance factor.
However, FEDAI has made exception in the following cases-

a) In the case of a bill under LC and where the reimbursement instructions says that
TT reimbursement is permitted than the transit period taken is 5 days because TT
reimbursement can be claimed by telecommunication system which is faster than
the normal delivery period of the documents to the foreign bank.
b) In case of usance bills where the due dates are calculated as per terms of contract-
 from the date of shipment
 from the date of bill of exchange
 from the date of acceptance of the drafts
 from the date of arrival of the ship at the port of destination
In all such cases the transit period is calculated as per above formula and no normal
transit period is permitted and thee rate of interest to be charged will be determined by
the bank concerned subject to RBI directive from time to time.
Foreign Exchange Selling Rate

In India there are two types of merchant selling rates-
1. TT Selling Rate: In case of sale of foreign currency, the TT selling rate is applied
where the bank does not have to handle documents. Also where the domestic currency
has been received in advance and foreign currency is parted with later. For example in
the case of issue of demand drafts, mail transfers, telegraphic transfers etc., other than
retirement of import bills, and Cancellation of foreign exchange purchased earlier. For
e.g. A DD for USD 100 was purchased by a student and now he wants to cancel the
same. In such a transaction the DD would be cancelled by applying the TT selling rate
and Rupee equivalent will be credited in the purchaser‟s account.
2. Bills Selling Rate: Bills selling rate is applied for handling of bills. This rate is applied
while handling an import bill under LC. For example, Bank has established an import
LC and the foreign bank has negotiated the documents as per LC terms and made
payment to the beneficiary by debiting the amount to our Nostro account or by
claiming reimbursement from the Nostro bank as per LC terms. In this kind of
transaction when the bill is received by the LC establishing Bank, i.e. the LC opening
branch of the bank, it will first verify the documents with the LC terms and if the
documents received are strictly as per LC terms, the LC opening branch will then lodge
the bill in their branch books and present it for payment to the customer on whose

Page |7
behalf the LC was established. After allowing the normal time for realisation the LC
opening bank will debit the account of the importer on whose request LC was
established by applying the Bills Selling Rate.
Exchange Rates for Non-Trade transactions

Separate rates are applied for transactions relating to purchase and sale of travellers
cheques and purchase and sale of foreign currency notes. These rates are as given below.
1. TC Purchase Rate: A tourist coming to India, travels with travellers‟ cheques to meet
his day to day expenses. If the tourist needs money he can approach an AD and encash
his travellers‟ cheques by tendering. The A.D. can obtain the tenderers signature on the
travellers cheque in the space provided for it and after matching the same, the A.D.
converts the foreign currency into Indian rupees and pays the tourist, in Indian rupees.
2. TC Selling: A person who intends to go abroad needs foreign currency for his stay,
food, purchases etc. The Indian Rupee is still not convertible hence a tourist or a
businessman needs to carry foreign currency when he travels abroad. For such a
person, travellers‟ cheques are the best option as it is safe to carry and encash. When
such persons approach an A.D. for release of foreign currency in the form of travellers‟
cheque, TC Selling rate is applied.
3. Currency Purchase: Exporters, Foreign tourist, NRIs and even Resident Indians bring
in foreign currency. As per FEMA 1999, such persons must approach an authorised
dealer and surrender the foreign currency which the A.D. may purchase by applying the
currency purchase rate and rupee equivalent is paid to the person who is tendering.
Except in the case of NRIs bringing in currency notes for the purpose of opening
FCNR account, all other transactions can be converted and rupee equivalent be paid.
4. Currency Selling: Currency notes are sold to all foreign bound tourists. However, there
is a cap as to how much a traveller from India can obtain foreign currency while
travelling abroad. The A.D should keep in mind the quantum fixed by RBI in this
regard. While selling currency notes, the A.D. will apply the currency selling rate
which is worse than the TC selling rate.
Facilities available for Residents-Foreign currency accounts for Residents

As per FEMA, resident Indians are expected to surrender foreign exchange acquired by
them and not spent, to an authorised dealer within a specified time if the amount of such
foreign exchange exceeds a specified limit. As a measure of liberalising foreign exchange
control regime, GOI/RBI has exempted returning Indians/ Resident Indians from the
requirement of surrendering foreign currency funds/assets acquired by them abroad or
received by them from abroad subject to some conditions.
They can retain their foreign currency accounts with banks abroad and can hold/ transfer/

Page |8
dispose their foreign currency assets without any permission from RBI. They enjoy
complete freedom in utilising these assets and also on income earned and sale proceeds
subsequently received from these assets.
They can also repatriate the proceeds of these assets and/or realise export proceeds and
hold them separately in India with Authorised dealers by opening accounts.
Some account that residents are allowed to open in foreign currency are discussed below.
1. Exchange Earners’ Foreign Currency [EEFC] Account

Exporters in the process of manufacturing might require imported inputs viz., a ready-made
garment exporter of say shirt as per the design requires imported button/zip or many a time
thread for embroidery. The exporter has to import these items from abroad and in order that
he can do this he will be required to purchase foreign currency from an Authorised dealer.
The rate applied for such a transaction is the TT Selling rate. When the exporter
manufactures the shirt after using the imported material, he exports it and while submitting
the bill to the A.D he finds that he gets a lower conversion rate i.e. in the process he incurs
a loss to that extent. Exports is a very competitive industry and a price difference of even ₹
10 per shirt can go against the exporter and he may not remain competitive in the export
market and therefore may not get the export order as his price is not competitive.
Given the backdrop, in order to give a boost to exporters to increase export of goods and
services from India, the GOI, in consultation with the RBI permitted exporters/ beneficiary
of a foreign exchange inward remittances to retain their export proceeds/ remittances in
foreign currency only in an account known as “EEFC” account so as to ensure that they do
not incur an exchange loss if they need to make payment in foreign currency at a later date.
Also gains if any, on account of appreciation of foreign currency vis-à-vis Indian Rupee
may accrue to the exchange earner.
As per the scheme part/ full value of the realised bill value/ remittance can be retained in
the foreign currency in the EEFC account.
Foreign currency remittances which are received pursuant to an undertaking or those

received for meeting any specific obligation is not eligible for EEFC facility. It may be
noted that such receipts are not foreign exchange earned.
Banks can maintain EEFC accounts in any convertible foreign currency. However, no
interest is paid on the balance maintained. Joint accounts are not permitted and no credit
facility can be sanctioned against EEFC balances.
The balance available in the EEFC account can be utilised by the account holders for-
a) Payment in foreign exchange to a resident in India for supply of goods/ services
including payment of air fare and hotel expenditure.

Page |9
b) Payment of custom duty.

c) Payment in foreign exchange towards purchases from EOUs.
d) All permissible current and capital account transactions.
e) Trade related loans/ advances by an exporter to importer abroad.
Banks may issue a separate cheque book with words “EEFC Account” superscribed on
each cheque leaf. However, the Bank while passing the cheque for payment should ensure
that the transaction is permissible as per FEMA 1999 and RBI directives in force. No loan
whether fund based or non-fund based should be granted against the security of the EEFC
account.
For the purpose of accounting in the books of the bank, conversion of foreign exchange
will be done at a notional rate only after realisation of the bill or receipt of remittance.
Special Features
In “Non interest earning Current account only” in USD, GBP, EURO, AUD & CAD.
 There is no any requirement of minimum balance in EEFC account (Box item in Cir
IO/95/2012)
 Cheque book facility in case of EEFC for making payments from these accounts for
eligible purposes.
 No credit facilities, either fund based or non-fund based should be permitted against the
security of balances held in EEFC accounts. Further no lien can be marked for the
balance held in EEFC accounts.
2. Resident Foreign Currency (RFC) Account

Resident Foreign Currency account scheme was floated by the RBI to enable eligible
returning Indians/PIOs to open and maintain account in India in foreign currency so that
should there be an occasion to go back abroad, the NRI/PIO should not suffer exchange
loss. The condition imposed by the RBI for opening the account was that the NRI
concerned should have stayed out of India for a continuous period of not less than one year
and should have returned back to India on or after 18th April 1992.
However NRIs approaching AD for opening RFC accounts, but have stayed out of India
for less than one year, should not be turned away but should be requested to submit an
application in form RFC which should be duly recommended for consideration and
processing to the RBI. RFC accounts opened with the specific approval of Reserve Bank
will however be governed by the conditions stipulated by Reserve Bank while granting
such approval.
The salient features of the scheme are-

Eligibility:
a) Persons of Indian nationality or origin, who, having been resident outside India for a

P a g e | 10
continuous period of not less than one year, have become persons resident in India on
or after 18thApril 1992 (for arriving at the period of continuous stay abroad of not
less than one year, short visits to India on personal grounds like meeting family
members/relatives or on health grounds which do not indicate the person's
intention to stay in India for an indefinite period may be ignored) are eligible to
open and maintain RFC accounts with A.D. in India in any freely convertible foreign
currency.
b) A Non-Resident Indian (NRI) is a person resident outside India, who is a citizen of

India or is a person of Indian origin.
c) A Person of Indian Origin (PIO) for this purpose is defined in Regulation 2 of FEMA
Notification as-
 Citizen of any country other than Bangladesh or Pakistan, if (a) he at any time held
Indian passport; or
 He or either of his parents or any of his grandparents was a citizen of India by
virtue of the Constitution of India or the Citizenship Act, 1955 (57 of 1955); or
 The person is a spouse of an Indian citizen or a person referred to in sub-clauses
given.
 „Close relative‟ means relative as defined in Section 6 of the Companies Act, 1956.
d) „A Person of Indian Origin‟ means an individual (not being a citizen of Pakistan or

Bangladesh or Sri Lanka or Afghanistan or China or Iran or Nepal or Bhutan) who at
any time, held an Indian Passport or who or either of whose father or mother or whose
grandfather or grandmother was a citizen of India by virtue of the Constitution of India
or the Citizenship Act, 1955 (57 of 1955).
Notes
a) Persons who returned to India prior to 18thApril 1992 after having been resident outside
India for a continuous period of not less than one year are also eligible to open RFC
accounts if they are holding valid specific permission/license from Reserve Bank as on
17thJuly 1992 to maintain foreign accounts or to hold other foreign currency assets
abroad or they are in receipt of pension or other monetary benefits from their overseas
employers subsequent to their return to India even if they did not maintain foreign
currency accounts or hold other foreign currency assets abroad.
b) Persons holding RIFEE permits or Reconversion facility have been given option to
continue those facilities or avail of RFC account facility. These options can be
exercised at one stroke or in part amounts during the validity period of RIFEE permit
or Reconversion facility. Accordingly, holders of RIFEE permit or Reconversion
facility are also eligible to open RFC accounts.
Explanation: For the purpose of this Scheme: A person (not being a citizen of Pakistan or
Bangladesh) shall be deemed to be of Indian origin, if, he at any time held an Indian

P a g e | 11
passport, or he or either of his parents or any of his grandparents was a citizen of India by
virtue of the Constitution of India or the Citizenship Act, 1955 (57 of 1955),or that person
is the spouse of an Indian citizen or of a person of Indian origin (not being a citizen of
Pakistan or Bangladesh).
Type of Accounts Permitted

RFC accounts can be maintained in the form of current or savings or term deposit accounts,
where the account holder is an individual and in the form of current or term deposits in all
other cases.
Rate of Interest
Rate of interest payable on the funds held in RFC accounts may be decided by authorized
dealers on the basis of market rates. No interest shall be payable on balances held in the
form of current accounts.
Nomination Facility
a) RFC accounts shall have the nomination facility as in the case of resident rupee
accounts.
b) On the death of a RFC account holder, the balance in the account may be repatriated to
nominees to the extent of his/ their entitlement, if on the date of death of the account
holder such nominees are resident outside India.
c) To the extent any nominee is a person resident in India on the date of the death of
account holder, the amount may be paid to him in equivalent Indian rupees.
Permitted Credits
The allowable credit transactions into an RFC account are given below-
a) Remittance in convertible foreign currency from outside India through normal banking
channels representing-
 Funds in bank accounts outside India forming part of eligible assets held by the
eligible person.
 Income such as dividend, interest, profit, rent, etc. earned on eligible assets held by
the eligible person.
 Sale proceeds of eligible assets.
b) Pension or other monetary benefits received from outside India in convertible foreign
currency, through normal banking channels, arising out of employment taken up
outside India by the eligible person prior to his returning to India.
c) Interest earned on RFC account.
d) Foreign currency notes/ travelers cheques brought into India by the eligible person,
provided that where the amount tendered exceeds US$ 10,000 or its equivalent or
where the value of foreign currency/bank notes exceeds US$ 5000 or its equivalent
have been declared on the Currency Declaration Form (CDF).
e) Transfers from other RFC accounts of the account holder.
f) Balances in any NRE/FCNR Account (other than in NRE rupee accounts of persons

P a g e | 12
resident in the erstwhile Bilateral Group countries which have been funded in non-
convertible rupees) in the name of the eligible person standing to his credit at the time
of his arrival in India. No penalty would be payable for premature withdrawal of NRE/
FCNR deposits in such cases.
g) Un-utilized entitlement under any valid RIFEE permit or Reconversion facility granted
by the Reserve Bank.
h) Unspent foreign exchange surrendered by the RFC account holders provided A.D is
satisfied that the foreign exchange/currency concerned had in fact been released for
travel etc. abroad by debit to the same RFC accounts and the amount of foreign
exchange/ currency is surrendered within the stipulated period as required under the
Exchange Control regulations.
Eligible Assets
Assets acquired or held otherwise than in contravention of the Act by an eligible person,
while he was resident outside India (non-resident), in the form of deposits in banks outside
India, investments in foreign currency shares or securities or immovable properties situated
outside India or investments in business etc. outside India and include foreign exchange
earnings through employment, business or vocation outside India taken up or commenced
by such person while he was resident outside India.
Permitted Debits
a) The funds in RFC accounts are free from all restrictions regarding utilisation of
foreign currency balances including any restriction on investment in any form
outside India.
b) The funds in the RFC account may be allowed to be freely utilised by the account
holder for any bona fide remittance outside India through normal banking channels
including for investments abroad provided the cost of such investments and/or any
subsequent payments required therefore are met out of RFC account.
c) Withdrawals/payments from such accounts, other than for remittances outside
India, orfor payments in foreign currency authorised to be made in India by Reserve
Bank, shall be permitted by the authorised dealer only in equivalent Indian rupees.
Reserve Requirements
Funds held in RFC accounts are exempt from CRR/SLR requirements.
Loans/Overdrafts against the Deposits

No loan/overdraft shall be granted by authorised dealers against balances in RFC accounts.
Transfer of Balances on becoming Non-resident

Funds held in RFC account may be freely remitted abroad or credited to fresh NRE/ FCNR
accounts in the event of the account holder becoming non-resident by virtue of his going
abroad for employment, etc.

P a g e | 13
Other features
 CA/SB, FDR, KDR in 5 currencies (USD, GBP,EURO, AUD & CAD)
 No Cheque Book Facility for SB and CA.
 Min. Bal. 100 units. For SB. No Interest if balance below 1000 USD &CA
 FDR, KDR min. 1000 units.
 Min Interest Payable USD 10 per Half Year.
 Period for FDR Min.1 month Max.3 years. Minimum 1 week to 1 month period
also, but USD 2, 50,000/- or its equivalent in other currencies.
 RFC KDR 1 year to 3 years
 Non-Resident individual(s) may include resident close relative(s) as a joint
holder(s) in their RFC bank accounts on 'former or survivor' basis. However, such
resident close relative, now being made eligible to become joint account holder,
shall not be eligible to operate the account during the life time of the resident
account holder.
 Employees/Ex-employees of the bank are not eligible for preferential rate of
interest of 1% on RFC deposits.
Ref. Circulars Forex Desk Card updated upto 31/12/2015
Resident Foreign Currency (Domestic) Account(RFC)

Resident Indians are allowed to retain up to US$ 2000 or its equivalent in aggregate,
provided that such foreign exchange is in the form of currency notes, bank notes and
travellers cheques-
a) Was acquired by him while on a visit to any place outside India by way of payment for
services rendered abroad (not arising from any business in or anything done in India).
b) Was acquired by him, from any person not resident in India and who is on a visit to
India, as honorarium or gift or for services rendered or in settlement of any lawful
obligation.
c) Was acquired by him by way of honorarium or gift while on a visit to any place outside
India.
d) Represents the unspent amount of foreign exchange acquired by him from an
authorised person for travel abroad.
e) Was received in settlement of any lawful obligation from any person not resident in
India.
A person resident in India is also allowed to, hold and maintain with an A.D. in India a
Foreign Currency Account to be known as Resident Foreign Currency (Domestic)
Account, out of foreign exchange acquired in the form of currency notes, bank notes and
travellers cheques from the sources specified at items (a) to (d) above.
The account will be maintained in the form of current account and shall not bear any
interest.

P a g e | 14
There will be no ceiling on the balances held in the account.
Cheque facility will be available.
Debits to the account shall be for payment towards current/capital account transactions in
accordance with the existing foreign exchange regulations.
The facility of opening of RFC (Domestic) Account is in addition to the existing RFC
facility, and retention of foreign exchange in cash and/or travellers cheques up to US$
2000 or its equivalent is available.
Canara Bank – Other features

No interest.
 Permitted currency USD, GBP, EURO.
 Min.bal.1000 units
 Resident individual(s) may include resident close relative(s) as a joint holder(s) in their
RFC bank accounts on 'former or survivor' basis. However, such resident close relative,
now being made eligible to become joint account holder, shall not be eligible to operate
the account during the life time of the resident account holder.
Ref. Circulars Forex Desk Card updated upto 31/12/2015
Unit summary
 Types of merchant rates and selection of rate for forex transactions.
 Facilities available for Residents: Foreign Currency accounts for Residents- Exchange
Earners Foreign Currency Accounts, Resident Foreign Currency Accounts, and Resident
Foreign Currency (Domestic) accounts.


(Banking & Finance)

and Market Risk
Management
Unit 9
Page |1
Introduction
“NEIPL”.

Page |2
Unit 9
 Definition and introduction to types of risks with special reference to Banks.
 BASEL norms.
 RBI directives on risk management.
Introduction
Banking and financial services all over the world are regulated by the Monetary Authority
of the respective countries. This is mainly because banking and financial services are the
backbone of an economy. A healthy and robust banking system is a requirement for any
economy to function smoothly and to develop at a rapid space.
An element of “Risk” is associated with every activity – be it business or daily routine – in

every sphere of activity there is something unpredictable which cannot be visualized and
which is unforeseen. You plan something and work on it but the end product could be
totally different than what is was planned, and his element of uncertainty is referred to as
Risk”.
It is here that the role of a Monetary Authorities to regulate functioning of the financial
institutions in the respective countries is felt the most. In India, this function is discharged
by Reserve Bank of India.
Regulations play an important role in the management of Risk. The regulatory framework
sets up the constraints and guidelines that inspires risk management practices and
stimulates the development and enhancement of the internal risk models and risk
management processes of banks.
Regulations promote better definitions of risks, and create incentives for developing better
methodologies for measuring risks. In this unit, regulations and guidelines that govern
“Risk Management” will be discussed.
Risk
Risk can be defined as, “Uncertainties resulting in adverse outcome, adverse in relation to
planned objective or expectations”.
“Financial Risks are uncertainties resulting in adverse variation of profitability or outright

losses”.
The banking balance sheet includes advances, deposits and borrowings, which arises out of
commercial and retail banking operations, and all assets and liabilities products have
following characteristics:

Page |3
1. They are normally held until maturity.

2. The accrual system of accounting is applied.
The basis characteristics of any product that is whether assets or liabilities, is that they are
held until maturity, and maturity mismatch between assets and liabilities result in excess or
shortage of liquidity. This mismatch is commonly known as “Liquidity Risk”.
Banking as we know is a very sensitive industry and there is always a change in the rate of
interest for all the assets and liabilities held in the books of the bank. With the changes in
the Rate of Interest [ROI], the Net Interest Income [NII] of the bank also undergoes a
change. This is known as Interest Rate Risk [IRR].
Despite proper Credit assessment and securing the assets of the bank by obtaining
collaterals, there are chances of the assets being not serviced by the borrowers due to
various reasons. This is called as “Default Risk”.
Banking transactions being handled by human beings, there are chances of human failures
in the form of omission or commission, deficiencies in information system and system
failures, inadequate or non-adherence to lay down systems and policies of the bank,
internal processes and external events etc. This is known as “Operational risk”.
The securities held by the bank are marketable and can be traded in the exchanges:
1. They are normally not held until maturity and positions are liquidated in the market
after holding in for a period.
2. Mark-to-Market system is followed and the difference between market price and book
value is taken to Profit and loss account.
Thus trading book is subject to adverse movement in market prices until they are disposed.
This is termed as Market Risk.
The Trading Book may have market abroad, as well, if it is permitted by the laws of the
land. Instruments having less demand have less trading volume and are exposed to
liquidation risk and there is likelihood of adverse price movement. Certain securities are
exposed to credit risk or default risk, which may arise due to failure on the part of the
counter party in honouring his commitment. Trading book is also exposed to operational
risk that may arise due to human failure, non-adherence to internal processes and external
factor.
The different types of financial risks that banks are exposed to are discussed further in this
unit.

Page |4
Types of risks - Banking

The major “Risk” that the Banks are exposed to while doing the business of banking are-
1. Market Risk: Market Risk is the sensitivity of the value of a financial instrument or
portfolio to changes in market parameters. The parameters can be anything from
interest rates, foreign exchange rates, commodity prices and/or equity market indices.
For example, the Bank invested money in 9% bonds and later on they found that now
the ROI offered is 10% - the Bank undergoes a loss of 1%. In the same breath, a Bank
takes a position of say one million dollar at say ₹ 62.50 and in the next minute the bank
finds that the dollar rate has gone down and now the rate of exchange is say ₹ 62.25.
Similarly the Bank purchased shares from the stock exchanges at say ₹ 100 per share
and within a short time it finds that the market indices are going down and the share is
now traded at say ₹ 95 per share – In all such cases the term used is “Market Risk”.
2. Interest Rate Risk: Any fluctuation in interest rates brings about changes in the value
of underlying assets and liabilities. This could be due to mismatched positions. The
effect of the Risk change is directly felt on the profitability of the Bank. Interest Rate
Risks can be viewed in two ways. Its impact is on the earnings or its impact on the
economic value of the bank‟s assets, liabilities and off-balance sheet position.
3. Gap or Mismatch Risk: In the bank‟s balance sheet, if there are assets and liabilities
and off balance sheet items with different maturities, principal amounts, than there are
chances of creating exposure to unexpected changes in the level of market interest
rates.
For example- A branch of a bank has Vehicle loan account maturing in two years at a
fixed rate of interest say 8.25% which is funded by a deposit maturing in six months
5% – In such a situation, there is every likelihood of the interest margin undergoing a
change due to re-pricing, resulting in impacting the profitability of the Bank concerned.
In other words, where an asset maturing in two years at a fixed rate of interest have
been funded by a liability maturing in six months, the interest margin would undergo a
change after six months causing variation in net interest income.
4. Basis Risk: Basis Risk means interest rate of different assets, liabilities and off balance
sheet items may undergo a change. For example, interest received on an asset product
may fall than the rate of interest on corresponding liability, creating variation in net
interest income.
5. Yield Curve Risk: In a floating interest rate scenario, banks may price their assets and
liabilities based on different benchmarks that is treasury bills yields, fixed deposit rates,
call money rates, MIBOR etc. In case banks use two different instruments maturing at
different time horizon for pricing their assets and liabilities, any non-parallel
movements in yield curves would affect the NII. The movements in yield curve are
rather frequent, thus, banks should evaluate the movement in yield curves and the
impact of that on the portfolio values and income. It may be noted that yield curve risk

Page |5
is a type of basis risk and this arises with respect to different maturity sectors.
6. Foreign Exchange Risk: Exchange rate is highly volatile and any fluctuations pose a
major risk to all the banks handling foreign exchange transactions. This risk is
attributed to open positions in foreign currencies held by the dealer. In other words a
bank may suffer losses as a result of adverse exchange rate movements during a period
in which it has open position, either spot or forward or a combination of the two, in an
individual foreign currency.
While limits on open position and stop loss levels are the traditional methods of
measuring and controlling market risks, they ignore the correlations between price
movements of the different exposures in a trading book viz., currencies, equities,
bonds, commodities.
7. Default or Credit Risk: A bank borrower or a counterparty failing to meet its

commitments in accordance with the agreed terms is known as Default Risk or Credit
Risk. In Banks, loans and corporate bonds are the largest and most obvious source of
credit risk.
8. Counter Party Risk: This risk is a part of Credit Risk and is related to non-
performance of the trading partners due to counterparty‟s refusal and or inability to
perform.
9. Embedded Option Risk: In case of significant changes in the market interest rates,
there are chances of borrowers repaying their outstanding in Cash Credit/Overdrafts
accounts as also customers exercising their call/put options on bonds/debentures and/
or premature withdrawal of term deposits. The embedded option risk may become a
reality in a volatile situation like changes in the interest rates. The quickness with
which the rate of interest changes, the higher will be the embedded option risk to the
banks NII, resulting in reduction of projected cash flow and income for the bank.
10. Reinvestment Risk: The uncertainty at which the future fresh cash-flow or matured
deposits will get invested is called Reinvestment Risk. Any mismatches in cash flows
would expose the banks to variations in their Net Interest Income as the market interest
rate charts moves up and down violently.
11. Net Interest Position Risk: In a situation where the bank has assets which yield more
than the liabilities where the bank has to pay less, interest rate risk arises, if the market
interest rates goes downwards. In such a situation, the banks will find that there is
reduction in NII as the market interest rate declines and increases when the interest rate
rises.
12. Settlement Risk: Till the early seventies, Settlement Risk was not taken seriously by
the Management, although such instances in the past have been a part of financial

Page |6
transactions.
Settlement risk is prevalent in all cross border deal because of time factor that can be
explained as follows:-
For example, you make a deal of purchase of say USD one million today with a foreign
bank operating from say Mumbai. You pay that Mumbai bank Indian rupee before the
close of banking hours in India say 3.30 P.M., whereas you receive the foreign
currency in your Nostro account in New York tomorrow. In the meantime, suppose if
that bank fails, then you will not receive the foreign currency but you have already paid
the Indian Rupees.
13. Liquidity Risk: Liquidity risk is of two types. One is related to a specific product or
market and the second one is related to general funding of the institution.
In the first type of risk, a bank may not be able to offset or cover the outstanding to
near the previous market price due to inadequate market depth or because of market
disruptions, say, for example, suddenly a bandh is declared and the market operations
gets disrupted. At that point of time, the bank finds that it has an over-bought position
of the securities. Due to market disruption, the bank is not in a position to sell the over-
bought position due to lack of buyers because of the bandh – a situation of this kind is
known as Liquidity crisis. However in such a situation, if the liquidity situation of the
bank concerned is satisfactory it will not face much problem. But in case if the liquidity
situation of the bank concerned is far from satisfactory then it will face liquidity crisis.
The liquidity risk is further bifurcated into following types-
a) Funding Risk: Many a times there is sudden huge outflow of funds which is not to
the knowledge of the bank concerned. This sudden outflow could be due to
unanticipated withdrawal/non-renewal of deposits pertaining to whole sale or retail
deposits.
b) Time Risk: There are situations where the expected in-flow is not there due to asset
turning non-performing. In simple language one term loan for ₹ 500 lakh was to
close but did not close and turned NPA.
14. Call Risk: This arises due to crystallization of contingent liabilities for example, Bank
Guarantee got invoked and Bank has to pay.
15. Operational Risk: Many a times, it is found that procedures and controls are far from
satisfactory. Operational risk is mainly attributed to human errors, systemic failures
including inadequate procedures and controls. This is one area which depends upon the
internal systems of a bank concerned.
To quote an example as to how internal control can play havoc if the systems and
procedure are not adhered to and if there are no controls over the same we can quote
the famous case of Barings Bank.
The Barings Bank was a merchant bank established in 1762. Its main business was to
undertake derivative business on Singapore exchange that is SIMEX. The business was
initially set up to undertake deals on SIMEX on behalf of its customers. In 1992, one of

Page |7
its Manager Mr. Nick Leeson, was able to convince its Management that he could
generate risk free profits by arbitraging the stock index future Nikkei 225 between
Osaka and Singapore Exchanges. Mr Leeson showed book profits of GBP 10 Million in
1993 and in the subsequent year that is in the year 1994 he showed a profit of GBP 28
Million.
The Bank which was nearly 232 years old came crashing down like a pack of cards one
fine morning when it found that there is severe liquidity crisis as the bank is not able to
meet its commitment.
After the failure of the Bank, investigations revealed the following-
a) Mr. Leeson would hide his losses and generate false profits by use of an internal
suspense account which he could manage without detection for nearly two years.
b) He kept on borrowing money from London market to fund his position and to
provide huge margin monies to exchanges.
c) Mr. Leeson was controlling both the front office and back office operations at that
point of time.
16. Transaction Risk: Transactions risk arises out of fraud, both external/internal, failed
business processes and the inability to maintain business continuity and manage
information.
17. Strategic Risk: Strategic Risk is the risk arising out of adverse business decisions,
improper implementation of decisions or lack of responsiveness to industry changes.
This risk is a function of the compatibility of an organisation‟s strategic goals, the
business strategies developed to achieve those goals, the resources deployed against
these goals and the quality of implementation.
18. Reputation Risk: Reputation Risk is the risk arising from negative public opinion. The
risk may expose the institution to litigation, financial loss, or decline in customer base.
To quote an example, one account holder of a private sector bank visited an ATM kiosk
and attempted to withdraw money. Unfortunately, the ATM machine was not having
enough cash in the machine and hence was not dispensing cash. The customer panicked
and started spreading news that the bank has no money left hence the ATM machine is
not dispensing cash. The news spread like wild fire and every account holder of that
particular bank attempted to withdraw as much money as possible resulting in almost
all the ATMs became cash less within a very short time. This led to further panic and
next day morning there was a huge queue of depositors outside that particular bank,
wanting to prematurely close their deposit account and withdraw money. Luckily, the
bank arranged for enough funds and when they started repaying each and every
customer which came for premature withdrawal, the customers realised that the bank is
not in liquidation and that the bank is having enough liquidity. However, within a span
of 2 days deposits amounting to ₹ 4,000 crore were withdrawn. Luckily, the bank
survived and the rumour that had spread stating that the reputation of the bank is at
stake was found to be not correct.

Page |8
19. Legal Risk: Banks having international operations has to comply with the legal
provisions of the country in which they have business transactions which may differ
from country to country. Undertaking a deal and conducting a business with customers
from across the countries require due care and keeping in mind the underlying legal
implications and frame work of the country. Compliance of local regulatory structure is
a must. The risk includes the question whether the documentation executed is legally
tenable in the court of the law as also whether all the rules and regulations of the
country in which the bank is operating has been complied with.
Legal risks arise when it transpires that the counter party with whom the transaction has
been concluded, does not have the legal or regulatory authority sanction to undertake
such transactions. In other words the counter party is incapacitated for engaging in such
a deal, resulting in non-enforceability of contract. Legal risk also includes compliance
and regulations related risks, arising out of non-compliance of prescribed guidelines or
breach of governmental rules, leading to penalties being imposed by law enforcing
agencies of the country concerned.
20. Country Risk: Sudden change in rules and regulations in a country where business is
concluded may land the bank in trouble as both the borrowers as well as the counter
party has no control for non-performance as the situation has arisen due to external
factor that is constraints or restrictions imposed by a country.
The first task would be to identify the risk factors associated with the core business line
vis-a-vis Credit decision that the bank takes. Any financial assistance extended by a
Bank, a repayment schedule is also fixed. Based on the repayment schedule fixed, if
there are defaults in repayment of the loan it gives rise to a credit risk. In normal
banking language credit risks is limited to the outright default of the counter party.
Thus, on the date of the sanction, the banks hold advances in their balance sheets at par.
In case the borrower defaults in repayment of the instalments, then the value of the
assets is written down in the form of a provision. The provisioning norms based on the
period of defaults and the values the bank may realise of the securities available are
standardized across the border.
Regulations
The need for risk based regulation in a changed world environment was felt in the
seventies. The lack of strong and robust regulations weighed heavily on the banks‟
management. Commercial banking meant essentially collecting resources for the purpose
of lending. Regulators concern was safety for the industry and monetary management. The
rules and regulations were so strict that there were limited scope of the operations of the
various credit institutions and limited their risks as well. There were low incentives for
change and competition.

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The objectives of Regulations are-

1. Protecting the interest of the depositors as depositors cannot impose a real market
discipline on functioning of banks.
2. Improving the safety of the banking industry, by imposing capital requirements in-line
with bank‟s risks. It is interesting to note that Regulatory Authorities impose
recognition of the core concept of the capital adequacy principle and of „risk based
capital‟ which in other words mean – capital should be in consonance with the element
of risk. This means a quantitative assessment of risks as well.
3. Promoting stable business and supervisory practices.
4. Levelling the competitive playing field of banks through setting common benchmarks
for all players.
5. Controlling and monitoring “Systemic Risk”.
A regulatory framework, on a cross country basis for reconciling risk control and yet
maintaining a level playing field for a fair competition became necessary. This job was
undertaken by the Basel Committee on Banking Supervision [BCBS].
The Basel Committee on Banking Supervision [BCBS] under the auspices of the Bank for
International Settlements [BIS], comprising of Central Bank Governors of G10 countries
that is Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain,
Sweden, Switzerland, UK and USA [It may be noted today in G-10, there are 13 countries
but it is popularly known as G-10] was formed.
BCBS meets four times in a year and is ably assisted by a working group comprising of 30
technical personnel and a task force which meets regularly. Thus, BCBS has been
instrumental in standardising bank regulations across jurisdictions with special emphasis
on defining the role of regulators in cross-jurisdictional situations.
The functioning of BCBS in the post deregulations era will be discussed in detail in this
unit.
BASEL
The Basel Committee on Banking Supervision [BCBS] is formed basically by G-10
countries, consisting of 13 countries that do not possess any formal supranational
supervisory authority and its conclusions were never backed by a legal force.
It is a body comprising of 13 countries who have come together to formulate broad

supervisory standards and guidelines and recommends statements of best practices in the
expectation that individual countries will initiate steps to implement them through a
detailed arrangements – statutory or otherwise which are best suited to their own National
System.

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The reasons behind formulating best practices is to encourage convergence towards

common approach and common standards without attempting detailed harmonization of
member countries, supervisory techniques and at the same time to close gaps in
international supervisory coverage in pursuit of two basic principles-
1. That no foreign bank establishment should escape supervision.
2. That supervision should be adequate.
In the year 1988, the Basel Committee published a set of minimal capital requirements for
banks which is popularly known as the 1988 Basel Accord. This was enforced by bringing
in a law in the G-10 countries in the year 1992.
The 1988 Basel Accord primarily sought to put in place a framework for minimum capital
requirement for banks that was linked to credit exposure as also define capital for the
purpose of capital adequacy.
Bank assets were classified into five categories that is grouped according to credit risk
carrying risk weights of 0, 10, 20, 50 and 100%. Assets were to be classified into one of
these risk buckets based on the parameters of counter party (sovereign, public sector
enterprise or others), collaterals (mortgages of residential property) and maturity.
Generally government debt was categorised at 0%, bank debt at 20% and other debts at
100%. Off balance sheet exposures such as performance guarantees and letters of credit
were brought into the calculation of risk-weighted assets using the mechanism of variable
credit conversion factor.
The Accord provided a detailed definition of capital-

 Tier 1 or core capital consists of equity and disclosed reserves.
 Tier 2 or supplementary capital, which could include undisclosed reserves, asset
revaluation reserve, general provision and loan-loss reserves, hybrid (debit/equity)
capital instruments and subordinated debt.
In 1996, the BCBS brought in an amendment to the 1988 Basel Accord to provide an
exclusive capital cushion for the price risks to which banks are exposed, particularly those
arising from trading activities.
This amendment which came into effect from the year 1998 is as follows-
1. Allows banks to use proprietary in-house models for measuring market risks.
2. Banks using proprietary models must compute VaR daily, using a 99th percentile, one-
tailed confidence interval with a time horizon of ten trading days using a historical
observation period of at least one year.
3. The capital charge for a bank that uses a proprietary model will be the higher of the
previous day‟s VaR and three times the average of the daily VaR of the preceding 60
business days.

P a g e | 11
4. Use of “back-testing” (ex-post comparisons between model results and actual

performance) to arrive at the “plus factor” that is added to the multiplication factor of
three.
5. Allows banks to issue short term subordinated debt subject to a lock-in clause (Tier 3
capital) to meet a part of their market risks.
6. Alternate standardized approach using the “building block” approach where general
market risk and specific security risk are calculated separately and added up.
7. Banks to segregate trading book and mark-to-market all portfolio/position in the
trading book.
8. Applicable to both trading activities of banks and non-banking securities firms.
As discussed herein above, the 1988 Basel Accord primarily sought to put in place a
framework for minimum capital requirement for banks that was linked to credit exposure
as also define capital for the purpose of capital adequacy. Hence, Bank assets were
classified into five categories that is grouped according to credit risk, carrying risk weights
of 0, 10, 20, 50 and 100%. Assets were to be classified into one of these risk buckets based
on the parameters of counter party (sovereign, public sector enterprise or others),
collaterals (mortgages of residential property) and maturity.
Generally government debt was categorised at 0%, bank debt at 20% and other debts at
100%. Off balance sheet exposures such as performance guarantees and letters of credit
were brought into the calculation of risk-weighted assets using the mechanism of variable
credit conversion factor.
Linking of risks with capital in terms of the Basel I Accord required a revision for the
following reasons-
1. Study revealed that the Credit Risk assessment under Basel I was not risk-sensitive
enough. Capital required assessment under the Basel I Accord was not being able to
differentiate between banks with lower risk and banks with higher risks. For example
exposure on a Triple A rating company and a company with B rating was treated
identically for the purpose of capital adequacy. Both would be placed in 100% risk
weight category although risks associated with them could be quite different.
2. It promotes financial decision-making on the basis of regulatory constraints rather than
on the basis of economic opportunities. Capital requirements for all corporate account
being the same, it encouraged financing of assets with more risks for higher returns,
whereas a sound decision, should take into account, risk and return characteristics of an
asset.
3. It did not recognize the role of a credit risk mitigate, such as credit derivatives,
securitizations, collaterals and guarantees, in reducing credit risk.
4. It did not take into account operational risks of banks.
Besides the above, the main objective to revise the 1988 Accord was-
1. To develop a frame work that would strengthen the soundness and stability of the

P a g e | 12
international banking system.

2. To ensure that it does not become a source of competitive inequality among
internationally active banks and yet have a capital adequacy regulation that is
sufficiently consistent.
3. To help promote the adoption of stronger risk management practices by the Banking
industry.
BASEL II
The revised Basel Accord was named as Basel II and its important features are as follows:
1. Significantly, more risk-sensitive capital requirements take into account Operational
risk of banks apart from credit and market risks. It also provides for risk treatment on
securitisation.
2. Greater use of assessment of risk provided by banks‟ internal systems as inputs to
capital calculations.
3. Provides a range of options for determining the capital requirements for credit risk and
operational risk to allow banks and national regulators to select the approaches that are
most suitable.
4. Capital requirement under new Accord is the minimum. It has a provision for
supplementary capital that can be adopted by National Regulators.
5. The Accord in fact promotes stronger risk management practices by banks by providing
capital incentive for banks with better risk management practices.
It may be noted that Capital requirement under Basel II does not include liquidity risk,
interest rate risk of banking book, strategic and business risks. These risks would be under
“Supervisory Review Process. If supervisors feel that the capital held by a bank is not
sufficient they could require the bank to reduce its risk or increase its capital or both.
Where a bank under 200 basis point interest rate shock, faces reduction in capital by 20%
or more, such banks would be outliers.
The Basel II Accord is based on three pillars-

Pillar I – Minimum Capital Requirements
1. Capital for Credit Risk
a) Standardised Approach
b) Internal Ratings Based (IRB) Foundation Approach
c) Internal Ratings Based (IRB) Advanced Approach
2.Capital for Market Risk

a) Standardised Approach (Maturity Method)
b) Standardised Approach (Duration Method)
c) Internal Models Method
3.Capital for Operational Risk

a) Basic Indicator Approach

P a g e | 13
b) Standardised Approach
c) Advanced Measurement Approach
Pillar 2 – Supervisory Review Process

1. Evaluate Risk Assessment
2. Ensure soundness and integrity of banks‟ internal process to assess the adequacy of
capital.
3. Ensure maintenance of minimum capital with PCA for short fall.
4. Prescribe differential capital, where necessary that is where the internal processes are
slack.
Pillar 3 – Market Discipline

1. Enhance disclosure
2. Core disclosures and supplementary disclosures
3. Timely – Once in six months.
BASEL III
Basel III Accord was released in December, 2010 which is a continuation of the effort
initiated by the Basel Committee on Banking Supervision to enhance the banking
regulatory framework under Basel I and Basel II. Basel III has essentially been designed to
address the weaknesses that become too obvious during the 2008 financial crisis world
faced. The intent of the Basel Committee seems to prepare the banking industry for any
future economic downturns. This latest Accord seeks to improve the banking sector's
ability to deal with financial and economic stress, improve risk management and strengthen
banks' transparency.
Basel III guidelines are aimed to improve the ability of banks to withstand periods of
economic and financial stress as the new guidelines are more stringent than the earlier
requirements for capital and liquidity in the banking sector.
Basel III Requirements will affect Indian Banks as and when implemented by banks in
India as per the guidelines issued by RBI from time to time. It will be a challenging task
not only for the banks but also for the Government of India. It is estimated that Indian
banks will be required to raise ₹ Six lakh crore in external capital in next five years or so
i.e. by 2020.Expansion of capital to this extent will affect the returns on the equity of these
banks especially public sector banks.
The basic structure of Basel III remains unchanged with three mutually reinforcing pillars
referred under Basel II accord.
1. Better Capital Quality: One of the key elements of Basel III is the introduction of
stricter definition of capital. Better quality capital means the higher loss-absorbing
capacity. This in turn will mean that banks will be stronger, allowing them to better
withstand periods of stress.
2. Capital Conservation Buffer: Now banks will be required to hold a capital conservation

P a g e | 14
buffer of 2.5%.The aim of asking to build conservation buffer is to ensure that banks
maintain a cushion of capital that can be used to absorb losses during periods of
financial and economic stress.
3. Countercyclical Buffer: The countercyclical buffer has been introduced with the
objective to increase capital requirements in good times and decrease the same in bad
times. The buffer will slow banking activity when it overheats and will encourage
lending when times are tough i.e. in bad times. The buffer will range from 0% to 2.5%,
consisting of common equity or other fully loss-absorbing capital.
4. Minimum Common Equity and Tier 1 Capital Requirements: The minimum
requirement for common equity, the highest form of loss-absorbing capital, has been
raised under Basel III from 2% to 4.5% of total risk-weighted assets. The overall Tier 1
capital requirement, consisting of not only common equity but also other qualifying
financial instruments, will also increase from the current minimum of 4% to
6%.Although the minimum total capital requirement will remain at the current 8%
level, yet the required total capital will increase to 10.5% when combined with the
conservation buffer.
5. Leverage Ratio: A review of the financial crisis of 2008 has indicted that the value of
many assets fell quicker than assumed from historical experience. Thus, now Basel III
rules include a leverage ratio to serve as a safety net. A leverage ratio is the relative
amount of capital to total assets (not risk-weighted).This aims to put a cap on swelling
of leverage in the banking sector on a global basis.3% leverage ratio of Tier 1 will be
tested before a mandatory leverage ratio is introduced in January 2018.
6. Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be
created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)
are to be introduced in 2015 and 2018, respectively.
Implementation of Basel-III in India

The RBI issued the final guidelines on 2nd May, 2012.
Major features of the guidelines are:
1. Guidelines would become effective from January 1, 2013 in a phased manner. This
means that as at the close of business on January 1, 2013, banks must be able to declare
or disclose capital ratios computed under the amended guidelines. The Basel III capital
ratios will be fully implemented as on March 31, 2019.
2. The capital requirements for the implementation of Basel III guidelines may be lower
during the initial periods and higher during the later years. Banks needs to keep this in
view while Capital Planning;
3. Guidelines on operational aspects of implementation of the Countercyclical Capital
Buffer. Guidance to banks on this will be issued in due course as RBI is still working
on these.
4. For the financial year ending March 31, 2013, banks will have to disclose the capital
ratios computed under the existing guidelines (Basel II) on capital adequacy as well as
those computed under the Basel III capital adequacy framework.
5. The guidelines require banks to maintain a Minimum Total Capital (MTC) of 9%

P a g e | 15
against 8% (international) prescribed by the Basel Committee of Total Risk Weighted

assets. This has been decided by Indian regulator as a matter of prudence. However,
banks will need to raise more money than under Basel II as several items are excluded
under the new definition.
6. Of the above, Common Equity Tier 1 (CET 1) capital must be at least 5.5% of RWAs;
7. In addition to the Minimum CET 1 capital of 5.5% of RWAs, (international standards
require these to be only at 4.5%) banks are also required to maintain a Capital
Conservation Buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1
capital.CCB is designed to ensure that banks build up capital buffers during normal
times (i.e. outside periods of stress) which can be drawn down as losses are incurred
during a stressed period.
8. Indian banks under Basel II are required to maintain Tier 1 capital of 6%, which has
been raised to 7% under Basel III. Moreover, certain instruments, including some with
the characteristics of debts, will not be now included for arriving at Tier 1 capital;
9. The new norms do not allow banks to use the consolidated capital of any insurance or
non-financial subsidiaries for calculating capital adequacy.
10. Leverage Ratio: Under the new set of guidelines, RBI has set the leverage ratio at 4.5%
(3% under Basel III).Leverage ratio has been introduced in Basel 3 to regulate banks
which have huge trading book and off balance sheet derivative positions. However, in
India, most of the banks do not have large derivative activities so as to arrange
enhanced cover for counterparty credit risk. Hence, the pressure on banks should be
minimal on this count.
11. Liquidity norms: The Liquidity Coverage Ratio (LCR) under Basel III requires banks
to hold enough unencumbered liquid assets to cover expected net outflows during a 30-
day stress period. In India, the burden from LCR stipulation will depend on how much
of CRR and SLR can be offset against LCR. Under present guidelines, Indian banks
already follow the norms set by RBI for the statutory liquidity ratio (SLR) and cash
reserve ratio (CRR), which are liquidity buffers. The SLR is mainly government
securities while the CRR is mainly cash. Thus, for this aspect also Indian banks are
better placed over many of their overseas counterparts.
12. Countercyclical Buffer: Economic activity moves in cycles and banking system is
inherently pro-cyclic. During upswings, carried away by the boom, banks end up in
excessive lending and unchecked risk build-up, which carry the seeds of a disastrous
downturn. The regulation to create additional capital buffers to lend further would act
as a break on unbridled bank-lending. The detailed guidelines for these are likely to be
issued by RBI only at a later stage.
RBI directives on risk management

Banks operating in India are required to maintain regulatory capital as per the directives
issued by country‟s regulatory authority i.e. the Reserve Bank of India [RBI].
The RBI, for this purpose, have issued guidelines specifying prescribed minimum capital

P a g e | 16
adequacy ratio that banks are required to maintain, criteria for capital funds and modalities
for computation of risk weighted assets as per Basel II.
Effective from 31st March, 2009, all commercial banks in India, other than local areas
banks [LABs] and Regional Rural Banks [RRBs] are required to compute risk weighted
assets based on standardized approach for credit risk, standardized duration approach for
market risk and basic indicator approach for operational risk. It may be mentioned that
migration to internal rating based approach for credit risk, internal model based approach
for market risk and standardized approach/advanced measurement approach for operational
risk would be permitted by RBI on a case by case basis for which banks are to obtain
necessary approval from RBI.
The following will give a broad idea of extant directives on regulatory capital
requirements-
1. Minimum capital requirement.
2. Capital Funds
3. Computation of RWAs for credit risk – Standardized Approach.
4. Computation of Capital Charge for Market Risk – Standardised Duration Approach
5. Computation of Capital Charge for Operational Risk – Basic Indicator Approach.
6. Computation of CRAR.
[Full details are available in RBI circular No. DBOD No. DB.BC.21/21.06.001/2009-10
Dated 01.07.2009 on the subject: “Master Circular – Prudential guidelines on Capital
Adequacy and Market discipline – Implementation of the New Capital Adequacy
Framework [NCAF]”.
Some of the above directives will be discussed in detail in this unit.
Minimum Capital Requirement: Banks are to maintain a minimum level of tier I capital
and total capital [Tier I + Tier II] based on the level of risk weighted assets. The ratio of
tier I capital to total risk weighted assets is called “Tier I CRAR” (CRAR stands for capital
to risk weighted assets ratio).
Total CRAR: Banks which have implemented Basel-II framework effective 31st March,
2008, were required to maintain minimum capital to risk weighted ratio [CRAR] for the
financial year 2008-2009 at 9% of risk weighted assets calculated as per Basel-II
framework or 8.1% of risk weighted assets calculated based on Basel-I framework,
whichever is higher. For the financial year 2009-2010 and beyond, they are required to
maintain a minimum capital at 9% of risk weighted assets calculated as per Basel-II
framework or 7.2% of risk weighted assets calculated based on Basel-I framework,
whichever is more.
Banks which have implemented Basel-II framework effective 31st March, 2009, are

P a g e | 17
required to maintain minimum capital to risk weighted ratio [CRAR] for the financial year
2009-10 at 9% of risk weighted assets calculated as per Basel-II framework or 8.1% of risk
weighted assets calculated based on Basel-I framework, whichever is more. For the
financial year 2010-11 and beyond, they are required to maintain a minimum capital at 9%
of risk weighted assets calculated as per Basel-II framework or 7.2% of risk weighted
assets calculated based on Basel-I framework, whichever is more.
Total CRAR is „[Eligible total capital funds] + [RWAs for Credit Risk + RWAs for Market
Risk + RWAs for Operational Risk]‟
In addition to above, effective from 31st March, 2010 all the banks to maintain Tier-I
Capital Adequacy ratio at 6% at least.
Tier-I CRAR is „[Eligible Tier I capital funds] + [RWAs for Credit Risk + RWAs for
Market Risk + RWAs for Operational Risk]‟
Capital Funds: The liabilities in a bank‟s balance sheet that qualifies as tier I capital and
tier II capital have been specified. Total capital is sum of Tier I capital and Tier II capital.
Tier-I capital funds would include the following-

a) Paid up equity capital, statutory reserves and other disclosed free reserves.
b) Capital Reserves arising out of sale proceeds of assets.
c) Innovative perpetual debt instruments [IPDIs], which meet the regulatory requirements
advised by RBI for this purpose limited to maximum of 15% of total Tier-I capital as
on 31st March of the previous financial year.
d) Perpetual non-cumulative preference shares [PNCPS], which meet the regulatory
requirements advised by RBI for the purpose subject to a limit such that total of IPDIs
and PNCPs does not exceed 40% of total Tier-I capital at any point of time.
Tier-I capital would equal the sum of these items but net of-
a) Intangible Assets
b) Deferred tax assets (DTAs) associated with accumulated loss
c) DTA (excluding DTA associated with accumulated loss) net of Deferred Tax Liability
(DTLs) if it has a positive value.
d) Other items as prescribed in the Master Circular of RBI.
Total capital funds equals to Tier-I capital fund (computed in accordance with the Para
mentioned above) and Tier-II capital.
Elements of Tier-II capital are-

a) Revaluation Reserves at a discount of 55%.
b) General provision on standard assets, floating provisions, provisions held for country
exposure, investment reserve accounts and excess provisions subject to a maximum of

P a g e | 18
1.25% of total risk weighted assets.

c) Upper Tier-II capital which includes PNCPs, redeemable non-cumulative preference
shares (RNCPS) and redeemable cumulative preference shares (RCPS) issued in
accordance with the regulatory guidelines for the purpose.
d) Subordinated debts issued and computed in accordance with the regulatory guidelines
for the purpose.
e) Innovative perpetual debt instruments [IPDIs] and Perpetual non-cumulative preference
shares [PNCPS], held in the books in excess of the prescribed limit and not included for
computing Tier-I capital.
Computation of RWAs for Credit Risk – Standardised Approach: Capital for Credit
Risk is required to meet abnormal losses arising out of risk of default of bank‟s borrowers.
However, in so far as risk of default across various borrowers and exposures differ, capital
requirement also differs. In view of this, under standardised approach, different but
prescribed risk weights are assigned to borrowers/types of exposure to differentiate risk of
default associated with them. Exposure duly risk weighted with appropriate risk weight is
termed risk weighted asset [RWA].Capital requirement for credit risk is based on RWA.
Total RWA for credit risk of a bank is the sum of risk weights of customer-wise credit
exposures covering its entire credit outstanding, where, the risk weight of an exposure
depends upon the type of borrower and exposure and the level of adjusted exposure.
Revised frame work for capital adequacy adopted by Reserve Bank of India specifies
varying risk weight depending upon type of exposures/borrowers. The adjusted exposure
would depend upon outstanding fund based facilities, un-availed portion of the sanctioned
fund-based facilities and outstanding non-fund based facilities net of allowable reductions
if such exposures are secured by permissible securities.
Therefore, determination of total RWAs for credit risk of a bank is basically a five stage
process comprising of-
 Determining Adjusted Exposure.
 Determining Allowable Reduction.
 Determining Applicable Risk Weight.
 Determining RWA for the exposure.
 Consolidation of RWAs of all exposures.
The concept of risks and the implications of risks in Banking have been discussed earlier in
the unit. Different types of risks in Banking have also been discussed in detail. It is
important to understand, identify and provide for risks. Regulations have a decisive impact
on the risk management that the banking industry undergoes. Regulations enhances the
safety of the banking industry and ensure a level playing field, promote sound business and
supervisory practices control and monitor “Systemic Risk” and thus protect the interest of
the depositors in particular and that of the economy in general.

P a g e | 19
Unit summary
 Definition and introduction to types of Risks with special reference to Banks.
 BASEL norms.
 RBI Directives on Risk Management.


(Banking & Finance)

and Market Risk
Management
Unit 10
Page |1
Introduction
“NEIPL”.

Page |2
Unit 10
 Operational risks in forex business with special reference to prevention of frauds.
 Cross border exposure, country risks-for banks and customers.
Introduction
Operational risks refer to the possibility of failure or malfunction of a system or procedure
or equipment. It is also the possibility of an internal or external resource working against
the interest of the organization or its clients. In the event of such occurrences the
organization suffers adversely.
In the case of foreign exchange, due to involvement of two or more countries in

transactions, the possibility of such a risk increases manifold. Therefore, approach to and
handling of cross border transactions is greatly influenced by such risk element.
Further, there is a possibility of a loss occurring due to failure of political or financial

system in any of the participating countries. Therefore, care has also to be taken to properly
evaluate the risk in dealing with importer or exporter in a particular country before
committing to a transaction. This is referred to „Country risk‟ and the exposures as „Cross
border exposure‟. This unit deals with operational and country risks in forex business.
Operational Risk
Operational risk has been defined by Basel Committee on Banking Supervision as “the risk of
loss resulting from inadequate or failed internal processes, people and systems or from
external events”.
Operational risk as defined by Basel Committee can be sub-classified as emanating from-

 Failure or inadequacy of internal systems and procedures.
 People managing business.
 Events external to the business.
Operational risk is more specific to an organization and its products. Policy framework,
internal processes and control mechanism to mitigate operational risk have therefore, to be
specific to the organization.
The RBI guidance note on Operational Risk Management states that “The design and
architecture for management of operational risk should be oriented towards banks' own
requirements dictated by the size and complexity of business, risk philosophy, market
perception and the expected level of capital. The exact approach may, therefore, differ from
bank to bank”

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Further, deregulation and globalisations of financial services, together with growing

sophistication of financial technology, are making the activities of banks more complex.
Therefore, the possibility of manifestation of operational risk has increased substantially and
in varied forms.
Examples of such risks faced by banks include-
1. Automation of transactions - If not properly controlled, the greater use of more
technology for automating transactions has the potential to transform risks from manual
processing errors to system failure risks, as greater reliance is placed on integrated
systems.
2. Emergence of E-Commerce – Growth of e-commerce brings with it potential risks (e.g.
internal and external fraud and system securities issues).
3. Outsourcing- Growing use of outsourcing arrangements and the participation in clearing
and settlement systems can mitigate some risks but can also present significant other risks
to banks.
4. Emergence of banks as very large volume service providers.
The Basel committee has identified the following types of operational risk events as having
the potential to result in substantial losses-
1. Internal frauds.
2. External frauds.
3. Employment practices and work place safety - For example, workers compensation
claims, violation of employee health and safety rules, organised labour activities,
discrimination claims, and general liability.
4. Clients, products and business practices - For example, fiduciary breaches, misuse of
confidential customer information, improper trading activities on the bank‟s account,
money laundering, and sale of unauthorised products.
5. Damage to physical assets - For example, terrorism, vandalism, earthquakes, fires and
floods.
6. Business disruption and system failures - For example, hardware and software failures,
telecommunication problems, and utility outages.
7. Execution, delivery and process management - For example, data entry errors,
collateral management failures, incomplete legal documentation, and unauthorized access
given to client accounts, non-client counterparty mis-performance, and vendor disputes.
As per the RBI‟s guidance note, initiatives required to be taken by banks with respect to
mitigation of operational risks include-
1. Board of Directors are primarily responsible for ensuring effective management of
operational risks in banks. The bank's Board of Directors has the ultimate responsibility
for ensuring that the senior management establishes and maintains an adequate and
effective system of internal controls.
2. Operational risk management should be identified and introduced as an independent risk
management function across the entire bank.
3. The senior management should have clear responsibilities for implementing operational

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risk management as approved by the Board of Directors.

4. The board of directors and senior management are responsible for creating an awareness
of Operational Risks and establishing a culture within the bank that emphasises and
demonstrates to all the levels of personnel the importance of Operational Risk.
5. The direction for effective operational risk management should be embedded in the
policies and procedures that clearly describe the key elements for identifying, assessing,
monitoring and controlling/ mitigating operational risk.
6. The internal audit function assists the senior management and the Board by independently
reviewing application and effectiveness of operational risk management procedures and
practices approved by the Board/ senior management.
7. The bank shall adopt one or the approaches suggested in Basel Committee
recommendations to calculate their capital requirement for operational risk and gradually
move towards more sophisticated approaches. The capital requirement so calculated shall
have to be maintained.
Operational Risk Management Framework

Central to successful operational risk management is-
1. Putting in place robust systems, procedures, check and control mechanisms to prevent
things going wrong.
2. Quick identification of an exception and resolving it in a satisfactory manner.
Operational risk management framework - RBI

The operational risk management framework suggested by the RBI is as follows-
Organisational set-up and Key responsibilities for operational risk management
Operational risk is intrinsic to a bank and should hence be an important component of its
enterprise wide risk management systems. The Board and senior management should create
an enabling organizational culture placing high priority on effective operational risk
management and adherence to sound operating procedures. Successful implementation of risk
management process has to emanate from the top management with the demonstration of
strong commitment to integrate the same into the basic operations and strategic decision
making processes. Therefore, Board and senior management should promote an
organizational culture for management of operational risk.
Ideally, the organizational set-up for operational risk management should include the
following with clearly laid out roles and responsibilities.
1. Board of Directors
2. Risk Management Committee of the Board
3. Operational Risk Management Committee
4. Operational Risk Management Department
5. Operational Risk Managers
6. Support Group for operational risk management

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Policy requirements and strategic approach

Key elements in the Operational Risk Management process include-
1. Well documented appropriate policies and procedures.
2. Efforts to identify and measure operational risk.
3. Effective monitoring and reporting.
4. A sound system of internal controls.
5. Appropriate testing and verification of the Operational Risk Management Process.
Given the vast advantages associated with effective Operational Risk Management, it is
imperative that the strategic approach of the risk management function should be oriented
towards-
1. An emphasis on minimising and eventually eliminating losses and customer
dissatisfaction due to failures in processes.
2. Focus on flaws in products and their design that can expose the institution to losses due to
fraud etc.
3. Align business structures and incentive systems to minimize conflicts between employees
and the institution.
4. Analyze the impact of failures in technology / systems and develop mitigants to minimize
the impact.
5. Develop plans for external shocks that can adversely impact the continuity in the
institution‟s operations.
Identification and Assessment of Operational Risk

Banks should identify and assess operational risks inherent in all material products, activities,
processes and systems. Banks should also ensure that before new products, activities,
processes and systems are introduced or undertaken, the operational risk inherent in them is
identified clearly and subjected to adequate assessment procedures.
In addition to identifying the risk events, banks should assess their vulnerability to these risk
events. Effective risk assessment allows a bank to better understand its risk profile and most
effectively target risk management resources.
Measurement of Operational Risk

A key component of risk management is measuring the size and scope of the bank‟s risk
exposures. As yet, however, there is no clearly established, single way to measure operational
risk on a bank-wide basis. Banks on their own develop risk assessment techniques that are
appropriate to the size and complexities of their portfolio, their resources and data
availability.
Monitoring of Operational Risk

An effective monitoring process is essential for adequately managing operational risk.
Regular monitoring activities can offer the advantage of quickly detecting and correcting
deficiencies in the policies, processes and procedures for managing operational risk.

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Promptly detecting and addressing these deficiencies can substantially reduce the potential
frequency and/ or severity of a loss event.
Additionally, banks should identify appropriate indicators that provide early warning of an
increased risk of future losses.
The frequency of monitoring should reflect the risks involved and the frequency and nature of
changes in the operating environment. Monitoring should be an integrated part of a bank‟s
activities.
Senior management should receive regular reports from appropriate areas. Reports should be
analysed with a view to improving existing risk management performance as well as
developing new risk management policies, procedures and practices.
Management Information Systems

Banks need to develop appropriate MIS so that regular reporting of pertinent information to
senior management and the Board of Directors is done.
Controls / Mitigation of Operational Risks

With regard to operational risk, several methods may be adopted for mitigating the risk. For
example, losses that might arise on account of natural disasters can be insured against. Losses
that might arise from business disruptions due to telecommunication or electrical failures can
be mitigated by establishing redundant backup facilities. Loss due to internal factors, like
employee fraud or product flaws, which may be difficult to identify and insure against, can be
mitigated through strong internal auditing procedures.
An effective internal control system requires-

1. Appropriate control structures are set up, with control activities defined at every business
level.
2. Appropriate segregation of duties and personnel.
3. Adequate and comprehensive internal financial, operational and compliance data, as well
as external market information about events and conditions that are relevant to decision
making.
4. Availability of reliable information that covers all significant activities of the bank.
5. Effective channels of communication to ensure that all staff fully understand and adhere
to policies and procedures affecting their duties and responsibilities and that other
relevant information is reaching the appropriate personnel.
6. Investment in appropriate processing technology and information technology security are
also important for risk mitigation.
7. Banks should establish disaster recovery and business continuity plans that address this
risk.
Adequate internal controls within banking organisations must be supplemented by an

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effective internal audit function that independently evaluates the control systems within the
organisation.
Operational risk can be more pronounced where banks engage in new activities or develop
new products (particularly where these activities or products are not consistent with the
bank‟s core business strategies), enter unfamiliar markets, and/ or engage in businesses that
are geographically distant from the head office. It is incumbent upon banks to ensure that
special attention is paid to internal control activities where such conditions exist.
Banks should have policies, processes and procedures to control and/or mitigate operational
risks. Banks should periodically review their risk limitation and control strategies and should
adjust their operational risk profile accordingly using appropriate strategies, in light of their
overall risk appetite and profile.
Banks should also establish policies for managing risks associated with outsourcing activities.
Outsourcing of activities can reduce the institution‟s risk profile by transferring activities to
others with greater expertise and scale to manage the risks associated with specialised
business activities. However, a bank‟s use of third parties does not diminish the responsibility
of management to ensure that the third-party activity is conducted in a safe and sound manner
and in compliance with applicable laws. Outsourcing arrangements should be based on robust
contracts and/or service level agreements that ensure a clear allocation of responsibilities
between external service providers and the outsourcing bank. Furthermore, banks need to
manage residual risks associated with outsourcing arrangements, including disruption of
services.
Depending on the scale and nature of the activity, banks should understand the potential
impact on their operations and their customers of any potential deficiencies in services
provided by vendors and other third party or intra-group service providers, including both
operational breakdowns and the potential business failure or default of the external parties.
Banks should ensure that the expectations and obligations of each party are clearly defined,
understood and enforceable. The extent of the external party‟s liability and financial ability to
compensate the bank for errors, negligence, and other operational failures should be explicitly
considered as part of the risk assessment.
Business Continuity Plan

Banks should have in place contingency and business continuity plans which should be
periodically reviewed so that they are consistent with the bank‟s current operations and
business strategies. These plans should be tested periodically to ensure that the bank would
be able to execute the plans in the unlikely event of a severe business disruption.
Capital Allocation for Operational Risk

In spite of putting all mechanism in place for managing operational risk, things can go wrong.
Basel Committee for Banking Supervision has therefore, recommended setting aside of some

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capital for covering operational risk. They have given guidelines for computing capital
requirement for covering perceived operational risk which has to be maintained by the banks.
Operational Risk Unique to Foreign Exchange Transactions

Aside of operational risk that all bank transactions, including foreign exchange transactions,
are subjected to as discussed above, foreign exchange transactions face some unique
operational risks. They suffer from additional risks since dealing with a person in some other
country or some other country itself is involved where things may go wrong. Essentially it
means that exposure of the bank crosses geographical boundary of the country – Cross
Border exposure. It is known as country risk and is sometimes also referred to as sovereign
risk. The foreign exchange transactions can be segregated into two broad categories-
1. Operations at the branches
2. Operations at the treasury
Operational risk at branch level can be managed in the manner discussed above except
country risk however, management of operational risk in treasury operations needs some
additional measures. It becomes all the more necessary as the quantum of transactions in the
treasury is very huge and any misadventure or mistake can result into huge loss for the bank.
It has been observed that losses are incurred in the ordinary course of trading and the dealer
tries to hide the losses either in the hope of recovering in subsequent deals or due to fear of
retribution, by doing larger and perhaps more aggressive deals and weakness in the internal
control system allows the dealers to do so. Ultimately the losses suffer when they become too
large to hide or there is a change in personnel.
A few suggested actions are as follows-

1. The first operational risk that treasury operations face is the absence of a manual of
instructions. Most of the banks do not have one. Therefore, the systems and procedures to
be followed are not very well documented. Therefore, if the treasury manual has not been
written it needs to be written and it should include-
a) The treasury policy, products to be dealt with and how to be used, their valuation etc.
b) Treasury functions, organization of the treasury and duties and responsibilities of each
segment with well-defined reporting channels.
c) Procedures to be followed including for deal making, deal entry, access to IT systems,
deal modification and amendment procedures etc.
d) Unambiguous setting of limits (day light/ overnight/ stop loss) for dealers to work
within and procedure to ensure their strict compliance.
2. The duties in the treasury have to be divided into the front office, mid office and back
office with each segment clearly defined roles. The principal objective of such a division
is to ensure an independent ongoing check on the activities of the dealers through back up
staff.
3. The dealing room should focus on only making deals, mid office on MIS and risk
management and back office on verification and settlement of deals and accounting/
reconciliation etc.

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4. No section should interfere with the work of the other section. While back office and mid
office may sometimes have overlap in work but dealing has to be completely isolated
from other works.
5. Since most of the deals are concluded over telephone and there is no record of the
transaction before deal slip is made, dealing room should have a voice recording machine
to record the conversation of dealers. Voice recording can also be used as evidence in
case of disputes.
6. Deal slips should be prepared by the dealers and should be passed on to the back office
for independent verification (of rates as well as with counterparty) and sending
confirmation.
7. Screen shots of Reuter/ Bloomberg screens being used by the dealers for quoting rates
should be taken randomly to cross check if the rates being quoted by the dealers are in
line with the market.
8. Compliance with dealer wise limits (daylight/ overnight/ stop loss) should be
independently verified by mid-office/ back-office (as per bank‟s policy) on an ongoing
basis and violations should be immediately brought to the notice of the senior
management.
9. Super profits earned by any dealer must invite enquiry as larger profits cannot be earned
by taking larger and undue risk.
10. It is useful to have separate dealers for only handling merchant (customer originated)
transactions and for trading in the inter-bank market. This will ensure separation of profit
made on merchant transactions and profit/ loss made from trading activity and mitigate
the possibility of losses in the trading activity being hidden by profits in merchant
transactions.
11. Procedure need to be laid down to ensure that a dealer who has input a deal in the system,
should not be able to delete, withdraw or amend it unless this action is authorised by the
mid office or back office. Giving/ generating a serial number for each deal and
maintaining deals register is also recommended.
12. Nostro reconciliation has to be ensured on an ongoing basis as any un-reconciled entry is
a potential risk. Sometimes, writing off/ absorption of un-reconciled items may become
necessary. It must be done only with the permission of appropriate authority.
13. Another equally important step towards operational risk management especially in
treasury operations is training of staff in the mid/ back office and internal audit. Quite
often the dealers get adequate training while the other staff of the treasury is neglected
leading to laxity in controls.
Adequate training to staff dealing with foreign exchange transactions at branch levels is
also equally important from the point of view of clearly understanding the complexities
involved and rules and procedures to be followed.
14. Proper and adequate IT systems go a long way in controlling operational risk.
15. Some banks send their dealers on surprise compulsory leave. This step helps in bringing
to surface any unauthorised transaction.

P a g e | 10
Country risks
Country risk is also known as sovereign risk and refers to the possibility of a country not
being able to service or repay its debt obligation to foreign lenders in a timely manner. It
arises when a country due to its precarious foreign exchange reserve position or other social
or political reasons puts an embargo on external payments. In effect it is credit risk triggered
by political or other reasons prevailing in a country.
Cross Border Exposure

Means loans or advances given to a counter party located in a different country. Such
exposures will not only suffer from credit risk but country risk also.
In larger sense, country risk is actually a combination of Political Risk, Sovereign Risk and
Economic Risk.
Country risk is managed in the following manner-

1. Under directions from the RBI every bank categorises countries of the world into 7
categories on the basis of risk rating provided by international rating agencies and also
ECGC.
2. Based on the risk rating of a country, each bank fixes a country exposure limit i.e.
maximum exposure that can be taken on a particular country at any given point in time.
Some countries may be given zero limit which would mean that such countries are off-
credit countries and no exposure can be taken without prior permission of the controlling
authority.
3. As a prudential measure all banks are required to make provision for country risk in case
exposure to a particular country is more than 1 % of its total assets. The provision can
range from 0.25% to 100% of net funded liability depending upon the risk rating of a
country.
Country risk from customers point of view

Customers who are engaged in cross border transactions are affected by country risk.
Evaluating country risks is a crucial exercise when choosing sites for international business,
particularly if investment is to be undertaken.
Further, each business confronts a unique set of country risks. As a result, a business should
evaluate country risk on its own and create its own strategy to manage the uncertainties those
risks entail.
A few of the measures that customers can take to manage country risk are-
A). Political Risk
Political Risk Evaluation
The Index of Economic Freedom ranks countries according to the impact that political
intervention has on business decisions, while the Corruption Perception Index indicates the
extent of corruption in each country.

P a g e | 11
The Index of Economic Freedom, which must be considered in a risk-return analysis, points
to the various ways in which a government may take away potential profits. The Corruption
Perception Index warns that doing business in certain countries will require clear corporate
practices for bribery.
Keeping a track of these two indices will be helpful in making a business decision-
1. Risk-Reward Analysis: Certain risks can be managed through insurance, hedging and
other types of financial planning, but country risk cannot be controlled through such
financial mechanisms. Country risk is one such risk. It may be measured in a risk-return
analysis. Higher the risk, higher should be the return built in the costing before starting
business.
2. Country Rating: Country rating done by ECGC and other rating agencies like Thomson
Reuters can be made use of by the customers also for making a business decision.
Further, it may be noted that International investment agreements between countries attempt
to limit political risks. And again Political risk insurance may be purchased as additional
protection against loss arising from such risks.
B). Economic Risks

Economic risk includes exchange rate, economic volatility, industry structure and
international competitiveness.
Exchange Rate Risk

Exchange rate movements have become a paramount consideration, as has the risk that a
government may simply lack the economic capacity to repay its loans. Many countries have
been experiencing ongoing fiscal deficits and rapid money-supply growth. Consequently,
inflation rates remain high in these countries, and devaluation crises appear from time to time
leading to depreciation in the value of home currency and/or artificial maintenance of
exchange rate at certain level.
Hedging mechanisms offer some hope for reducing foreign exchange risks, though generally
not without some cost.
Economic Volatility Risk

Economic stability depends upon a strong banking sector. Stronger the banking sector lesser
will be economic volatility hence better business environment in the country.
Industry Risk
The risk that an industry is likely to face in a country has to be evaluated. It may be lack of
require suppliers or resources or the general environment.
International competitiveness
Evaluating international competitiveness factor of a country becomes essential specially
before making an investment decision.

P a g e | 12
Intra-Country Economic Risk

Within a country different regions may have different economic risk. Some region may offer
high growth prospect and business friendly environment while other region may not. This
aspect has to be looked into.
Every banking operation including foreign exchange business, is at risk of turning into a
reason for loss due to failure of some system, procedure, process, machine or human being.
Foreign exchange transactions suffer from country risk in addition to all other risks arising
due to failures of such kinds. Operational risks are all pervading and needs to be managed by
putting in place sound policies, robust system and procedures, rigorous checks and balances
and constant review by the highest body in the organization. In spite of all the measures
taken, it can still manifest leading to losses. To protect the interest of depositors from such
eventuality, capital cover as recommended by the Basel Committee for banking supervision
has to be maintained by all the banks.
Unit summary
 Operational risks in forex business with special reference to prevention of frauds.
 Cross border exposure, country risks-for banks and customers.

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Post Graduate Diploma (Banking & Finance)

Activity in foreign exchange was confined to meeting merchants` and customers`

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Treasury and its role in Banks

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Mutual State Govt

Post Graduate Diploma (Banking & Finance)

Responsibilities of treasury including ALM

Post Graduate Diploma (Banking & Finance)

a) Ensuring optimum utilisation of available resources through proper investments.

Assets Liabilities Management (ALM)

Broad objectives of ALM are-

Post Graduate Diploma (Banking & Finance)

time bands/ buckets calling for-

Organisational structure of the treasury department of a commercial bank should facilitate

Post Graduate Diploma (Banking & Finance)

Post Graduate Diploma (Banking & Finance)

Primary market refers to fresh issues of Non-Government debt-paper by Corporate

2. Mid Office: The Mid-office is set up exclusively to provide information to the

Post Graduate Diploma (Banking & Finance)

Summary of Basic Treasury Functions

SGL and Constituent SGL accounts

Transactions in the SGL account

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account with RBI.

Constituent SGL accounts

Introduction to the investment portfolio of a domestic treasury

Post Graduate Diploma (Banking & Finance)

Thus the function of the Treasury was essentially liquidity management.

An illustrative list of domestic treasury instruments/products are-

Fixed Income Money Market and Derivatives Association [FIMMDA]

Post Graduate Diploma (Banking & Finance)

2. Transactions covered: The code is for all the transactions in Central/State

Examples of such manipulated/ fraudulent bids and offers are as under-

Post Graduate Diploma (Banking & Finance)

5. Erroneous Trades and Reversal-Role of DRC:

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considered as a “Big-figure” mistake by the seller. The market, however, reverts to

6. Composition of Dispute Resolution Committee (DRC):

Post Graduate Diploma (Banking & Finance)

a) Private Bank (presently Axis Bank Ltd) -1

7. Reporting of Erroneous Trades to FIMMDA:

9. Procedure for reversal of “Erroneous Trades”:In case “Erroneous Trades/ Big-

Post Graduate Diploma (Banking & Finance)

reversal, FIMMDA will seek the counterparty name/s from RBI.

Post Graduate Diploma (Banking & Finance)

Post Graduate Diploma (Banking & Finance)

Post Graduate Diploma