Kotak Mahindra Bank

1
Exchange rate mechanism
&
Forward contracts
K N Varadarajan
Head Treasury Operations
Kotak Bank
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2
Rate of exchange
Price of one currency expressed in terms of
another
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Commodity currency
The currency being priced
Usually for a fixed number of units
(Normally one)

Terms currency
The price currency
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Direct & indirect quotes
Direct
Foreign currency unit fixed &
Home currency varying
1 USD - Rs.51.45
Indirect
Home currency unit fixed &
Foreign currency varying
1 GBP = 1.5675 USD

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Two way quote
Bid and offer rates
1 GBP = USD 1.5670/75
Bid 1.5670 Offer 1.5675

Calling bank Quoting bank
- Can buy at 1.5675 Will buy at 1.5670
- Can sell at 1.5670 Will sell at 1.5675

Bid offer spread - difference between bid & offer
Points (pips) (last decimal place)
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Cross rate
Rate between two currencies derived via a third
currency if
1 $ = INR 51.45
1 $ = CHF 0.9600
1 CHF = 51.45
-------- = 53.5937 or 53.59
0.9600
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Chain rule
Procedure for calculating cross rate

?INR = 1 CHF
if 0.9600CHF = 1 USD
and 1 USD = INR 51.45
1 CHF = 1 x 1 x 51.45/0.9600
= INR 53.59
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Reciprocal rate
Procedure to change the terms in which
exchange rate is expressed
if 1 Euro = USD 1.3170
1 USD = 1 Euro/ 1.3170
1 USD = Euro 0.7593
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Trending rates
Quoting bank move their prices to reflect change in their
willingness to buy or sell
If market rates are
1 Euro = USD 1.3170 / 75
if a bank quotes
1 Euro - USD 1.3175 / 80
the dealer indicates his intention to buy Euro as the dealer is
willing to buy EUR at 1.3175 when the whole market is
buying at 1.3170
Here is indicating to the market that he wants to buy EUR as
he expects the price of EUR to go up.
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Quality of a quote
Fast reply
Narrow spread
Deal reasonable amount at rate quoted
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Reason to quote
Trend on the desired side


Spread benefit
Let us say there are six dealers operating in our dealing room and we
have quoted to one of our top clients for direct import bill payment for
USD 24 Mio.
Each of the six dealers have been asked to buy USD from the market
when the USD INR Rate in the market is 1 USD = INR 51.50/51.
Three dealers quoted this price to counterparty and the counterparty
sold USD to the bank at 1 USD = INR 51.50
Three dealers called other bank who quoted the same rate and bought
from them at 1 USD =INR 51.51

One of the question will arise when I quote what happens instead of
the counterparty selling to me but buys from me.
We can trend the price. For example when the inter bank market quote
is 1 USD = INR 51.50/51 and if our quote is 1 USD = INR 51.5050/51
which means that I buy USD at 51.5050 instead of others in the inter
bank market who are buying at 51.50. Even if we buy at 51.5050 it is
better than buying at 51.51.
It is better that we deal in our rates to get the spread benefit.
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Funds position
Net cash flow position in our NOSTRO accounts
Cash inflows and cash outflows
What are the expected in flows
What are the expected out flows
What is the expected closing balance?
The expected closing balance should be such
that we neither leave a huge balance in the
account (since we do not get much benefit by
way of interest) nor the account is over drawn
(since we will be charged overdraft interest at
high rates if the account is overdrawn)
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Net exchange position
Foreign currency purchased - foreign currency
sold (all transactions where there are currency
conversions taking place)
Long position (overbought)
-- gain if exchange rate rises
-- loss if exchange rate falls
Short position (oversold)
-- gain if exchange rate falls
-- loss if exchange rate rises
-- square
-- fluctuations in exchange rate does not affect P&L
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Spot & forward rates
Value dates
-- Date on which settlement takes place

Spot : second working day at both the centers
from the date of deal
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Forward rates
Obtained by adding/deducting disc/ premium
points
Premium/disc governed by interest differentials
The future price spread is wider than spot spread
Deduct disc point from price
Add premium points from price
Disc/premium in 2 way quote
Left side higher than right
Commodity is at a disc
Right side higher than left
Commodity is at a premium
Ascending order (add)
Descending order (deduct)
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Forward difference
Discount
Premium
Reflects the interest differentials in the
international market
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Interest differential explained
6 m interest rate in USA = 5%
6 m interest rate in UK = 6.5%
if spot rate is 1 GBP - 1.6500 USD
borrow in USD, deposit in UK
- borrow USD 1.65 million for 6 m
- convert that into GBP 1 mio at 1.65
- deposit GBP 1 mio for 6 m
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Interest payable in USD for 6 m
on USD 1.65 mio at 5% 41250 $

Interest receivable in GBP for 6m
on GBP 1 mio at 6.5% GBP 32500

After 6 months
GBP 1 mio + int 32500 = USD 1.65 mio + int 41250

GBP 1032500 = USD 1691250
Exchange rate is 1.6387
GBP is at a discount of 113 points against USD
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Currency at higher rate of interest is at a discount
Currency at a lower interest rate is at a premium

In Indian context, the forward premium / discount
is mostly driven by demand and supply rather
than the interest rate differential
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Exchange rate structure
Concept of base rate & card rate
Base rate : the rate prevailing in the inter bank
market
Card rate : The indicative rates for various types
of transactions
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Types of rates quoted
for merchant transactions
TT selling
Bill selling
T C selling
Currency selling
TT buying
Bill buying
Check purchase
T C purchase
Currency purchase
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Exchange margins
Transaction / customer specific

Application of margin :
Margins for purchases to be deducted from base -
margins for sales to be added to base

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Swaps
Simultaneous purchase and sale of fixed amount
for different value dates
Let us say the bank Buys USD 5 Mio value spot
(the second working day) and simultaneously
sold USD 5 Mio value date one month later this
transaction is known as swap.
Here the amounts bought and sold are the same
but the rates and value dates are different.
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Example # 1
Forward rate - Exports for USD/INR. Todays date is
27
th
April 2012.
USD/INR spot = 51.40/41
value date is 31.08.2012
premiums :
May: 17/19
June : 20/22
July: 23/25
Aug :27/29
What is forward rate if Bank wishes to keep 3 paise
margin ?
Answer = Rs.51.64

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Example # 2
Forward rate - Imports for USD/INR. Todays date is
27th April 2012
USD/INR spot = 51.40/41
value date is 31.08.2012
premiums :
May: 17/19
June: 20/22
July: 23/25
Aug:27/29
Sep: 31/33
What is forward rate if Bank wishes to keep 5 paise
margin ?
Answer = Rs. 51.75

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Example # 3
Forward rate - Imports for USD/INR.
Today is 27th April 2012
USD/INR spot = 51.40/41
value date is 16.09.2012
premiums :
May: 17/19 Aug 27 / 29
June: 20/22 Sep 31 / 33
July : 23/25
What is forward rate if Bank wishes to keep 4 paise
margin ?
Answer = Rs.51.76

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Example # 4
Cancellation of Forward contract Today is 27
th

April 2012
USD/INR spot = 51.40/41
Contract earlier booked for exports (for
delivery30.08.2012) at 51.89 for USD 500,000
What type of cancellation is this?
premiums : (30 day/month)
May:17/19 June: 20/22 July:23/25 Aug 27/29
What are cancellation charges, if the bank wishes to
keep 2 paisa margin?
Answer = 17 paise , Rs.85,000/--
Is it payable or recoverable?
Payable


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Example # 5
Booking of Cross currency forward contract -
Todays date is 27
th
April 2012
USD/INR spot = 51.28/30 GBP/USD =1.5490/92
for exports (90 days from bill of lading date which is
16
th
April 2012) for GBP 500,000

USD /INRpremiums cross currency fwds
May: 31/33 1 month 31/30
June : 54/56 2 month 54/53
July : 75/77 3 month 82/81
What rate do you quote for the transaction?


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Example # 5 (Contd)
What rate can he sell his GBP spot?
1GBP=USD 1.5490
But he is getting his GBP on 16/07/12 (90 days from
B/L date) . Hence he has to sell forward for
16/07/12.
Is GBP in premium / Discount?
Forward rate 3 month is 82/81 points.
It is in discount.
1.5490(-) 0.0082 = USD 1.5408
Now he has sold GBP and got USD and has to sell
USD against INR




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Example # 5 (Contd)
What rate can he sell his USD against INR spot?
1USD = INR 51.28
But he is getting his USD only on 16/07/12. Hence
he has to sell forward for 16/07/12.
Is USD in premia / Discount?
Rates for June is 54/56 and for July 75/77.
It is in Premium.
How much of premium to be passed on.
Rs.0.6450
How was this arrived? How is it different from the
GBP/USD quote
He can sell his USD at Rs.51.925
Final rate for GBP = 1.5408 X 51.925= Rs.80.01
(apply chain rule)



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Practically.
Normally customers complain
Rate is not favorable
Other banks offer better rate ( ! )

How do we cross check this information?

Can we offer products below our cost price?

Does any other industry offer such fine rates?



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FORWARD CONTRACTS
RBI 2011 -12 /379 Master circular on Risk Management and Interbank Dealings
updated as on 31
st
Jan 2012
32
Kotak Mahindra Bank
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Booking of Forward contracts
Contracted exposures
Ensure that an exposure exists
Underlying to be submitted to bank within 15 days
What if not submitted
Economic Exposures.
Cash settled.
No rebooking if cancelled.
Maturity of the hedge does not exceed the maturity
of the underlying transaction
Currency and hedge of the tenor left to the choice
of the customer
If hedge currency is different from that of the
underlying exposure the risk management policy
of the corporate approved by their Board must
permit such type of hedging.

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Contracted exposures
If he exact amount is not ascertainable the contract
can be booked on the basis of a reasonable
estimate
Foreign currency loans and bonds hedging
permitted only after approval is accorded by RBI
EEFC balances can be hedged but such contracts
can only be rolled and not cancelled.
Cancellation and re booking
Forward contracts booked by residents irrespective
of type and tenor of the underlying exposure, once
cancelled cannot be rebooked.
Non INR forwards can be rebooked only if the
corporate has submitted the exposure information
Substitution of contracts permitted on being
satisfied with the circumstances
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Booking of forward contracts
PROBABLE EXPOSURES BASED ON
PAST PERFORMANCE.
Last three years turn over or last years turn over which
ever is higher.
Limits computed separately for imports / export
transactions
Contracts booked during the current financial year (April
Mar) and outstanding contracts at any point of time should
not exceed
Eligible limit i.e. the average of the previous three financial
years actual export turnover or the previous years actual
export turn over which ever is higher for exports
25% of the eligible limit i.e. the average of the previous three
financial years actual import turnover or the previous years
actual import turn over which ever is higher for imports.
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Probable exposures
All forward contracts booked under probable
exposures both by exporters and importers (from
16
th
Dec 2011) will be on fully deliverable basis.
If cancelled gains cannot be passed on to the
customer.
Aggregate of overdue bills shall not exceed 10%
of the export turn over.
Limits once utilized cannot be reinstated either
on cancellation or on maturity of the contracts.
AD must initiate appropriate systems for
validating the PP limit at pre deal stage
Monthly report to RBI limits granted and utilised
by their constituents.

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Certificate requirements

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THANK YOU
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2012