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Foreign Exchange Market

Rajeev Kumar Jha

Treasury Department
Chinatrust Commercial Bank Ltd., New Delhi

A Comment

“There is no sphere of human influence in
which it is easier to show superficial
cleverness and the appearance of superior
wisdom as in matters of currency and
Winston Churchill
House of Commons 1946


Structure of the Presentation

Basic Concepts, Terminologies, Instruments &
Exchange Rate Regimes
Historical perspective
Foreign Exchange Trading & rate quotations
Role of Reserve Bank of India (RBI) in the FX

Foreign Currency vs. Foreign Exchange
As per Foreign Exchange Act, (Section 2),
(c) "Foreign Currency" means any currency other
than Indian currency;
(d) "Foreign Exchange" means includes any
instrument drawn, accepted, made or issued under
clause (8) of section 17 of the Banking Regulation Act,
1956, all deposits, credits and balance payable in any
foreign currency, and any drafts, traveler’s cheques,
letters of credit and bills of exchange, expressed or
drawn in Indian currency but payable in any foreign

Financial Markets
 Financial market is a place where
Resources/funds are transferred from
those having surplus/excess to those
having a deficit/shortage.


6 .  Price of each currency is determined in term of other currencies. Foreign Exchange Markets  The market where the commodity traded is Currencies.

e.g. In other words. What is an Exchange Rate ? Exchange Rate is the price of one country's currency expressed in another country's currency. 48. Rs.50 per one USD Major currencies of the World USD EURO YEN POUND STERLING . the rate at which one currency can be exchanged for another.

– Most important characteristic of a foreign exchange transaction is that it involves Foreign Exchange Risk. .What is a Foreign Exchange Transaction ? – Any financial transaction that involves more than one currency is a foreign exchange transaction.

 Public Sector/Government.  Inter Bank Brokerage Houses.  Resident Indians  Non Residents  Exchange Companies  Money Changers .  Corporate Treasuries. PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET  All Scheduled Commercial Banks (Authorized Dealers only).  Reserve Bank of India (RBI).


Components of a Standard FX Transaction  Base Currency (USD/INR)  ‘Dealt’ or ‘Variable’ Currency  Exchange Rate  Amount  Deal Date  Value Date  Settlement Instructions .

Canada 3) Spot Transaction : Settlement usually in two working days. . Value Date Conventions Currencies are traded both in Ready and forward value dates. In International FX transactions.g.g. e. 1) Ready: Settlement on the deal date. Spot is the Standard value date. Why Spot Date ?  Time Zone Difference  Herstat Risk 4) Forward Transaction: Settlement at some future date 12 ahead of the spot. India 2) Value Tom : Settlement on next day. e.

e. ‘Dealt Currency’ Number of variable or dealt currency unit in one unit of base currency.g. USD/INR= 48. ‘Pips (or Point): The smallest incremental move an exchange rate can make.50/60 .g. ‘Base Currency’ Vs. e. BC/VC USD/INR= 48.FX Rate Quotation: In the forex market rates are always quoted ‘two way’.50 / 60 Bid / Offer ‘Big Figure’: Term referring to the first digits of an exchange rate. These figures are rarely change in normal market fluctuations and are usually omitted in dealer quotes. Two way quote gives both ‘Bid’ and ‘Offer’. In international quotes base currency comes first.

The bank asking for the price or ‘quote’ is the ‘price taker’ or ‘user’. . Price maker Vs. Price Taker The bank quoting the price is ‘price maker’ or ‘market maker’.

60 Spread 00.10 In the international market. 15 .50/60 Buy One USD at 48.50 Sell One USD at 48. almost all currencies are quoted indirectly. RATE QUOTATION CONVENTIONS IN-DIRECT QUOTATION: “Price of one Unit of Foreign Currency in terms of Domestic Currency” e. USD/INR = 48.g.

2805/12 Buy One Euro at 1. RATE QUOTATION CONVENTIONS DIRECT QUOTATION: “Price of one Unit of Domestic Currency in terms of Foreign Currency” e.g.2805 Sell One Euro at 1.2812 Spread 0.0007 Five Currencies are quoted in Direct Terms 1) Pound Sterling 2) Euro 3) Australian Dollar 4) New Zealand Dollar 5) Irish Punt 16 . EURO= 1.

In the international market. .78/82 A visit to REUTERS ‘EFX=’ Page.g. almost all the currencies are quoted in terms of USD. e. JPY=105.

Currency with higher interest rates is at discount wrt currency having lower interest rate. . 3. 4. Forward rates depend upon interest rate differential between the two currencies. Forward rates are quoted as premium or discount over spot rate. Out right sale/purchase of a currency against the other for settlement at a future date at the predetermined exchange rate. FORWARD TRANSACTIONS 1. 2. Currency with lower interest rates is at premium wrt currency having higher interest rate. 5.

87 .50 DB for INR = Actual/365 DB for USD = Actual/360 Six month Forward Rate = spot rate (48.00% Spot Rate = 48. Calculating Forward Rate Interest rate of USD = 1.06*181/365)/(1+.50) x (1+ .25% Interest rate of INR = 6.0125*181/360) =59.

also at an agreed rate. FX SWAP Transaction “An FX swap is a contract to buy an amount of currency for one value date at an agreed rate. to the same counter party”. . and to simultaneously resell the same amount of currency for a later value date. FX swap is essentially a ‘funding’ or ‘Money Market’ transaction and does not involve exchange risk.

– Foreign exchange transactions are settled through Nostro and Vostro accounts. World Bank) maintain their Nostro accounts at Reserve Bank of India (RBI).g.  Vostro: their account with us. IMF. Reserve Bank of India (RBI) maintains various Nostro accounts in a number of countries.  Nostro: our account with banks abroad. Many multilateral agencies (e. – SWIFT (Society for Worldwide Interbank Financial Telecommunications) .

– Security guaranteed by Reuters Int. REUTERS dealing system etc REUTERS Dealing Terminal – Industry Standard for FX trading. – Password Protected. . Deals are done over Telephone. LIBOR) – Various Reserve Bank of India (RBI) pages on REUTERS. – Data about Interest Rates (e. – Maintains record of all transactions. News Terminal – Domestic Market Data/ news available on line. – Real Time Exchange Rate quotes of all major Currencies.g.

medical treatment etc. – Only ADs (Banks). – Fx available only for current account transactions. allowed to deal in Fx. – Residents not allowed to hold foreign exchange. with occasional devaluations. (goods & services) and some other personal transactions viz. . education. travel. – Reserve Bank of India (RBI) to fix its buying & selling rates for Authorized Dealers and their rates for customers.Pre-Reform era till early 90s ( The fixed ERM & Exchange Control Regime) – Fixed ERM.

. – Reserve Bank of India (RBI) to provide forward cover to ADs for importers and exporters as well as foreign currency loans mobilized by corporates from abroad. – Elaborate system of reporting by ADs to Reserve Bank of India (RBI). were bound to sell forex to an AD at rates prescribed by Reserve Bank of India (RBI). at its buying and selling rates for Authorized Dealers. Pre-Reform era till early 90s (The fixed ERM & Exchange Control Regime) – Reserve Bank of India (RBI) to buy and sell forex from and to ADs. – Exporters of goods and services.

– Money Changers were authorized to Deal in foreign exchange (Notes and TCs only). – FCAs Scheme was launched for Resident Pakistanis. Banks were required to surrender their FC deposits against purchase of forward cover from Reserve Bank of India (RBI).Market liberalization. The decade of 90s – Early nineties marked an era of liberalization of foreign exchange market. – Forward cover for FC loans also transferred to banks (under certain rules and regulations). . – Forward cover for imports and exports shifted to banks.

India was making gradual moves towards market based ERM. Post detonation crisis (May ’98) and move towards market based ERM.  Third currency rates to be quoted by banks. – In early 98. – The target was to put the currency on free float. quoting its buying and selling rates for ADs. .  Reserve Bank of India (RBI) also stopped giving customer’s buying and selling rate and gave a 1% band to the market.

1998. 80/20.g. Phased approach was adopted for transition to free float. As a first step Two-Tier ERM was introduced in July 21. Except for essential items (e. the rest of the trade transactions were settled through interbank market. Detonation of May 98 changed the way things were moving. Despite low reserves.Post detonation crisis (May ’98) and move towards market based ERM. Reserve Bank of India (RBI) made the decision of going ahead with fx market reforms. wheat l/cs) . Initially 50/50 . FINALLY 95/05 .

However. Currency was freely floated. Regulations pertaining to current account transactions remained more or less unchanged.Post detonation crisis (May ’98) and move towards market based ERM. However all transactions were to be done at interbank rate and every bank was to offer its own rate to customers. when it was finally done away with. Two-tier was finally abolished in May 1999. . an unofficial narrow band was imposed on banks. which remained there till July 2000.

– A host of regulations governing imports into India. – Out ward remittances for debt servicing. – Out ward remittances for services. Medical treatment etc. . Forex Transactions The Demand Side of inter-bank market – importers – buying foreign exchange to finance their imports. – PTEQ and BTQ.

– Repatriation of profit of foreign controlled companies and ‘freight collection’ etc. Forex Transactions The Demand Side of inter-bank market – Remittances on account of education abroad. – A host of other invisible payments. – Remittances on account medical treatment. . – Disinvestment through SCRA.

. – Home remittances. – Investment through SCRA. – Capital account receipts. Forex Transactions The Supply Side of inter-bank market – Exports – regulations governing export receipts. – A host of other invisible receipts. – Foreign Direct Investment.

1. . 2. Any sale or purchase of foreign currency entails foreign exchange risk. 3.Foreign Exchange Risk Exposure to exchange rate movement. Carrying net assets or net liability position in any currency gives rise to exchange risk. Foreign exchange transaction affects the net asset or net liability position of the buyer/seller.

(NOP) A measure of foreign exchange risk • NOP is the Net Asset/Net Liability position in all FCs together (Both B/S & Off B/S). • Net Asset Position is also called “LONG” or “Overbought “ position. • Net liability Position is also called “SHORT” or “Oversold “ position. NET OPEN POSITION. . • NOP is a single statistic that provides a fairly good idea about exchange risk assumed by the bank. • Its major flaw is that FX exposures in third currencies remain hidden.

$ 0.00 Euro) \ $ 0.EXAMPLE (NOP) (USD in Mio) Opening Position $ 0.00 Ready Purchases from Exporter $ 1.50 Fwd Sell to Corporate .40 NET OPEN POSITION $ 1.00 .00 Fwd Purchases from Corporate (1.$ 0.90 Ready Sell to importer ( 60 Mio Yen) .

.Introduction to Inter-bank FX activities Foreign Exchange Exposure FX Exposure is the higher of the long and short positions in FCs. EXAMPLE Currency-wise NOP in equivalent INR CURRENCY SHORT LONG Dollar -10 Yen 10 Euro -10 Pound 10 Total -20 20 Net Open Position is 0 while exposure is 20.

Foreign Exchange Markets Role of Reserve Bank of India (RBI) and linkages with economy .

 Regulate inter-bank forex transactions and monitor the foreign exchange risk of the banks. RBI’s Role in the Forex Market  To manage the exchange rate mechanism. .  Manage and maintain country's foreign exchange reserves.  Keep the exchange rate stable.

. • The limits are tied with the Paid up capital of the bank. which was based on foreign exchange volume handled by the bank. • Previously banks had NOP limit. RBI’s Role in the Forex Market • RBI has imposed foreign exchange exposure limits on banks (FE 12 of 1999).

Dealing room catered to the FX market only 3. TREASURY OPERATIONS AT RBI 1. Finally the dealing room and securities department were merged to form EDMD to from first ever Treasury of RBI. Money market was being looked after by the Securities department 4. All Central Banks have treasuries to implement policy objectives vis a vis EXCHANGE RATE & INTEREST RATES 2. It soon became apparent that the two cannot work in isolation with each other as the linkage between the money market & exchange market became pronounced 5. .

Functions of DMMD Market Monitoring Pro active monitoring of interbank MM & FX market by Front Office. . Gather data from various Sources. Real time remedial measures to remove distortions in the market. Prepare demand/supply forecast. Real time feedback to management.

A day in the Front Office  NOP report.  Oil payments. Wtd. FCA Conversion.  Forward transactions. Avg.  FX inflow/outflow statements.  Market monitoring – Market Flows and their impact on exchange rate.  Money Market liquidity  Forward rates  Market activity – if required  Rates Preparation – M2M. .

. – Historical trend of keeping long positions. Front Office Challenges – Small Market Size – Lumpy payments – ‘Leads’ and ‘Lags’. – The issue of ‘entries in transit’.

INTERVENTION  To keep exchange rate in line with macro objectives RBI has to intervene from time to time  Intervention is a process where FX is sold or purchased to keep the right amount of liquidity available in the FX market so that demand / supply equilibrium is maintained  Intervention can be in READY or FORWARD .


Off Site monitoring of banks by RBI Inputs of Computerized Reporting System (CRS) All individual foreign exchange transactions reported by each bank on daily basis on a floppy diskette Amount Currency Posting date Counter Party Rate Deal Date Type of Deal Maturity Date Mode of Deal .

Off Site monitoring of banks by RBI  Reports from CRS Exposure Report FE .25 balances & other deposits Nostro Balances Un-reconciled interbank deals .

banks/customers/currency Broker wise market volume report History of exchange rates .Off Site monitoring of banks by RBI  Reports from CRS Cont’d Reports for research & statistical purposes Types of transactions/customers/currency Business volume .trend analysis .

How does RBI manages exchange rate in the interbank market? • Non-Quantitative Tools • Quantitative Tools .

Non-Quantitative Tools • Moral suasion • facilitating large commercial outflows • Relaxation in FEEL .

banks’ net purchases or net sales in foreign exchange on a given day have to be within their FEEL. .  Presently FEEL for each bank is set at 10 % of it’s paid up capital.  In the presence of FEEL. How does RBI manages exchange rate in the interbank market? Quantitative Measures Foreign Exchange Exposure Limit (FEEL)  Basically restricts the banks to keep a net asset (long) or net liability (short) position in foreign currencies.

• RESERVE BUILDING . Currently RBI only indirectly intervenes in the market. • Such sale/purchase can be in spot or forward value • It can have two objectives To provide support to the market for lumpy payments To manage the Rs/$ parity • Intervention may be direct or indirect.Physical intervention • Direct selling or buying of foreign exchange by State Bank in the interbank market.

Thank You 52 .