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1.1 Exchange Rates and Forex Business

1.2 Basics of Forex Derivatives 1.3Corresponding Banking and NRI Accounts

Unit 1 - International Banking 1

1.Need for Foreign Exchange :
World Trade
Export & Import

Movement of Manpower & Capital

Travel & Tourism

Movement of Services etc.

Term foreign exchange is used to denote foreign currency

2. Definition
Deposits, credits and balances payable in foreign currency. Drafts, travellers Cheques, letter of credit or bill of exchange expressed or drawn in Indian currency but payable in foreign currency.

Drafts, travellers Cheques, L/Cs, etc. drawn by banks, institutions or persons outside India but payable in Indian currency

3. Exchange Rate means the price or the ratio or the value at which one currency is exchanged for another currency.

4. Forex Market Market Participants , Investors , Arbitrageurs & Speculators Market participants
Central Banks Reserves & Smoothening home currency Commercial Banks Forex , Investment & Speculation Investment Funds/Banks use exchange market as an investment vehicle Forex Brokers- Middle man Corporations Moves funds between countries & Speculation Individuals Investment , Travel & Tourism

5. Global Forex Market Size

3.20 trillion dollar per day or 3200 billion dollar per day

6. Characteristics of Forex Market

24 hours Market OTC Market Global Market ( no barrier / no specific location) Supports Large capital and trade flows Highly Liquid Highly Dynamic Settlement affected by time zone factor Markets influenced by government policies and controls

7. Factors Determining Exchange Rates: a) Fundamental Reasons

Balance of Payment surplus stronger currency Economic Growth rate high growth rate Fiscal policy expansionary policy Monetary Policy central bank influences money supply Interest Rates High domestic rates attract overseas capital , currency appreciates Political Issues - political stability stable currency

b) Technical Reasons Government Control can lead to unrealistic value and affect exchange rates. Free flow of Capital from lower interest rate to higher interest rate countries.( OPEC )
c) Speculative - Higher the speculation higher the volatility in rates . Provide depth & liquidity.

8. Types of exchange rate

The delivery of FX details can be settled in the following ways :
Value date the date on which the actual delivery of currencies take place.

Ready/cash- Settlement of funds on the same day (date of the deal).

Tom- Settlement of funds takes place on the next working day of the deal. If the settlement day Is holiday in any of the 2 countries, the settlement date will be next working day in both the countries.

Spot- Settlement of funds takes place on the second working day following the date of the deal
Forward- When the delivery of the currencies is to take place at a date beyond the Spot date, it is Forward Transaction and rate applied is called Forward Rate. Forward rates are derived from spot rates and are function of the spot rates.

Forward rate = Spot rate + Premium (-

If the forward value of a currency is higher than the spot value the currency is said to be at a premium If the above is reversed the currency is said to be at a discount The forward premium/discount is based on interest rate differentials of the two currencies involved. In a perfect market, with no restriction on finance and trade, the interest factor is the basic factor in arriving at the forward rate.

IF the Spot GBP against USD is being quoted at 1.6000

9. Direct Quote & Indirect Quote

The price of currency can be expressed in two ways i.e. Direct Quote, Indirect Quote. Direct Quote : One unit of foreign currency equal to so many units of home currency. Under Direct Quote, the local currency is variable E.g.: 1 USD = Rs 48.10 Direct Quote rates are also called Home Currency or Price Quotations.

Indirect Quote :
Under indirect Quote, the local currency remains fixed, while the number of units of foreign currency varies. E.g. RS100 = 2.05 USD

Globally all currencies (Except a few) are quoted as Direct Quotes, in terms of US$ Only in case of GBP (Great Britain Pound), , AU$ and NZ$, the currencies are quoted as indirect rates.

10. Cross Currency Rates: When dealing in a market where rates for a particular currency pair are not directly available, the price for the said currency pair is then obtained indirectly with the help of Cross rate mechanism. EX : To get GBP/ INR quote , work out GBP/USD & USD/ INR quote. IF GBP / USD is 1.60 , USD / INR is 48.10 calculate GBP / INR Quote.

11.Fixed Vs. Floating Rates:

The fixed exchange rate is the official rate set by the monetary authorities for one or more currencies. It is usually pegged to one or more currencies. Under floating exchange rate, the value of the currency is decided by supply and demand factors for a particular currency. Since 1973, the world economies have adopted floating exchange rate system. India switched to a floating exchange rate regime in 1993.

12. Bid & Offered Rates:

The buying rates and selling rates are referred to as Bid & Offered rate. Ex : USD / INR Quote of 48.10 / 11 Bidding ( Buying) USD at 48.10 Offering ( Selling ) USD at 48.11

Risk :
Unplanned event with financial consequences resulting in loss or reduced earnings. Uncertainty of the outcome.

The major risks associated with the dealing operations

Exchange Risk Settlement Risk Liquidity Risk Country Risk / Sovereign Risk Interest Rate Risk Operational Risk Legal Risk

Exchange Risk :
Arise mainly on account of fluctuations in exchange rates and/ or when mismatches occur in assets/ liabilities and receivables/ payables. Credit risk ( Settlement Risk) : Arises due to inability or unwillingness of the counterparty (bank or customer) to meet the obligations at maturity of the contract. Credit Risk is classified into Pre- Settlement Risk Settlement Risk

Pre Settlement Risk is the risk of failure of the counter party due to bankruptcy, Closure etc. before maturity of the contract thereby exposing the other party to cover the transaction at the ongoing market rates.

It entails the risk of only market differences and is not an absolute loss.
Settlement Risk is Failure of the counter party during the course of settlement, due to the time zone differences, between the two currencies to be exchanged. Ex : A bank in earlier time zone performs its part of the contract by delivering the currency to be delivered , but the counter party fails before delivery. Such an event is complete loss for the bank. Settlement risk could be eliminated if settlement systems operate on a single time basis.

Liquidity Risk When a party to a foreign exchange is unable to meet its funding requirement or execute a transaction at a reasonable price it creates liquidity risk. The positions cannot be liquidated except for high price. It is the potential for liabilities to drain from the bank at a faster rate than assets. The mismatches in the maturity patterns of assets and liabilities give rise to liquidity risk. Liquidity risk could also arise , in case the market turns illiquid leading to higher bid offer spreads.

Country Risk : It is risk of counter party situated in a different country unable to perform its part of the contractual obligations despite its willingness to do so due to local government regularizations or political or economic instability in that country. Country wise exposure limit

Sovereign Risk : Arises when the counter party is the foreign government itself or any of its agencies and enjoy sovereign immunity under the local laws with no legal recourse to the other party.
Sovereign clause . Third country jurisdiction.

Gap Risk/ Interest Rate Risk

It is the risk arising due to adverse movements of interest rates or interest rate differentials.
It is difficult for a bank to match its forward purchase and sales creating a mismatch in its assets and liabilities . This mismatch is referred to as GAP. Operation Risk Arising on account of human errors, technical faults, infrastructure breakdown, faulty systems and procedures or lack of internal controls.

Legal Risk
Arising on account of non-enforceability of contract against a counter party.