Foreign Exchange Market

BASIC CONCEPTS/TERMINOLOGIES
Foreign Currency vs. Foreign Exchange

As per Foreign Exchange Act, (Section 2),

1947.
(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, travelers cheques,
letters of credit and bills of exchange, expressed or
drawn in Indian currency but payable in any foreign
currency;

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

Foreign Exchange Markets

The market where the commodity traded is
Currencies.
Price of each currency is determined in term
of other currencies.

What is an Exchange Rate ?

Exchange Rate is the price of one country's
currency expressed in another country's
currency.
In other words, the rate at which one currency
can be exchanged for another.
e.g. Rs. 62.50 per one USD
Major currencies of the World

USD
EURO
YEN
POUND STERLING

What is a Foreign Exchange

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

PARTICIPANTS IN THE FOREIGN

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

FOREIGN EXCHANGE REGIMES

FIXED
PEGGED
COMPOSITE
MANAGED FLOAT

FREE FLOATING

Components of a Standard
FX Transaction

Base Currency
(USD/INR)
Dealt or Variable Currency
Exchange Rate
Amount
Deal Date
Value Date

Settlement Instructions

Value Date Conventions

Currencies are traded both in Ready and forward
value dates.
1) Ready: Settlement on the deal date. e.g. India
2) Value Tom : Settlement on next day. e.g. Canada
3) Spot Transaction : Settlement usually in two working days.
In International FX transactions, Spot is the Standard value
date.
Why Spot Date ?
Time Zone Difference
Herstat Risk
4) Forward Transaction: Settlement at some future date
ahead of the spot.
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FX Rate Quotation:
In the forex market rates are always quoted two way.
Two way quote gives both Bid and Offer.
e.g.
USD/INR= 48.50 / 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.

Pips (or Point): The smallest incremental move an exchange rate can make.
Base Currency Vs. Dealt Currency
Number of variable or dealt currency unit in one unit of base currency.
In international quotes base currency comes first.
e.g. BC/VC
USD/INR= 48.50/60

Price maker Vs. Price Taker

The bank quoting the price is price maker
or market maker.
The bank asking for the price or quote is
the price taker or user.

RATE QUOTATION CONVENTIONS

IN-DIRECT QUOTATION:
Price of one Unit of Foreign Currency in terms
of Domestic Currency
e.g. USD/INR = 48.50/60
Buy One USD at
Sell One USD at
Spread

48.50
48.60
00.10

In the international market, almost all

currencies are quoted indirectly.
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RATE QUOTATION CONVENTIONS

DIRECT QUOTATION:
Price of one Unit of Domestic Currency in terms of Foreign
Currency
e.g. EURO=

1.2805/12

Buy One Euro at

1.2805
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
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In the international market, almost all the

currencies are quoted in terms of USD.
e.g.
JPY= 105.78/82

A visit to REUTERS EFX= Page.

FORWARD TRANSACTIONS
1.

Out right sale/purchase of a currency against the

other for settlement at a future date at the
predetermined exchange rate.

2.

Forward rates are quoted as premium or discount

over spot rate.

3.

Forward rates depend upon interest rate

differential between the two currencies.

4.

Currency with higher interest rates is at discount

wrt currency having lower interest rate.

5.

Currency with lower interest rates is at premium

wrt currency having higher interest rate.

Calculating Forward Rate

Interest rate of USD
Interest rate of INR
Spot Rate
DB for INR
DB for USD
=

=
1.25%
=
6.00%
=
48.50
=
Actual/365
Actual/360

Six month Forward Rate =

spot rate (48.50) x (1+ .06*181/365)/
(1+.0125*181/360)
=59.87

FX SWAP Transaction
An FX swap is a contract to buy an amount of
currency for one value date at an agreed rate,
and to simultaneously resell the same amount
of currency for a later value date, also at an
agreed rate, to the same counter party.
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.
Nostro: our account with banks abroad. Reserve Bank
of India (RBI) maintains various Nostro accounts in a
number of countries.
Vostro: their account with us. Many multilateral
agencies (e.g. IMF, World Bank) maintain their Nostro
accounts at Reserve Bank of India (RBI).

SWIFT (Society for Worldwide Interbank Financial

Telecommunications)

Deals are done over Telephone,

REUTERS dealing system etc
REUTERS

Dealing Terminal
Industry Standard for FX trading.
Security guaranteed by Reuters Int.
Password Protected.
Maintains record of all transactions.

News Terminal
Domestic Market Data/ news available on line.
Real Time Exchange Rate quotes of all major Currencies.
Data about Interest Rates (e.g. LIBOR)
Various Reserve Bank of India (RBI) pages on REUTERS.

Pre-Reform era till early 90s ( The fixed

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

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, at its buying and selling rates for Authorized Dealers.
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.
Exporters of goods and services, were bound to sell forex to
an AD at rates prescribed by Reserve Bank of India (RBI).
Elaborate system of reporting by ADs to Reserve Bank of
India (RBI).

Market liberalization. The decade of 90s

Early nineties marked an era of liberalization of foreign
exchange market.
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).
Money Changers were authorized to Deal in foreign
exchange (Notes and TCs only).
Forward cover for imports and exports shifted to banks.
Forward cover for FC loans also transferred to banks
(under certain rules and regulations).

Post detonation crisis (May 98) and

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

Post detonation crisis (May 98) and

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

Post detonation crisis (May 98) and

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

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

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

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

Foreign Exchange Risk

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

NET OPEN POSITION- (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.
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.

EXAMPLE (NOP)

(USD in

Mio)
Opening Position
0.00

Ready Purchases from Exporter

1.00

Fwd Purchases from Corporate (1.00 Euro) \

0.90

Ready Sell to importer ( 60 Mio Yen)

$ 0.50

Fwd Sell to Corporate

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

RBIs Role in the Forex Market

To manage the exchange rate mechanism.

Regulate inter-bank forex transactions and

monitor the foreign exchange risk of the banks.
Keep the exchange rate stable.
Manage and maintain country's foreign
exchange reserves.

RBIs Role in the Forex Market

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

TREASURY OPERATIONS AT RBI

1. All Central Banks have treasuries to implement
policy objectives vis a vis EXCHANGE RATE &
INTEREST RATES
2. Dealing room catered to the FX market only
3. Money market was being looked after by the
Securities department
4. 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. Finally the dealing room and securities
department were merged to form EDMD to from
first ever Treasury of RBI.

Functions of DMMD

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

A day in the Front Office

NOP report.
FX inflow/outflow statements.
Oil payments,
Forward transactions.
Market monitoring Market Flows and their impact
on exchange rate.
Money Market liquidity
Forward rates
Market activity if required
Rates Preparation M2M, Wtd. Avg, FCA
Conversion.

Front Office Challenges

Small Market Size
Lumpy payments
Leads and Lags.
Historical trend of keeping long positions.
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

OTHER FX RELATED FUNCTIONS

OFFSITE MONITORING
DAILY RATES FOR MARKET
THIRD CURRENCY ACTIVITY FOR GoP
PAYMENTS
RESERVE MANAGEMENT

Off Site monitoring of banks

by RBI
Inputs of
Computerized
Reporting System

All individual foreign

exchange transactions
(CRS)
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

Off Site monitoring of banks

by RBI
Reports from CRS Contd

Reports for research & statistical purposes

Types of transactions/customers/currency
Business volume - banks/customers/curre
Broker wise market volume report
History of exchange rates - 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

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.
Presently FEEL for each bank is set at 10 % of
its paid up capital.
In the presence of FEEL, banks net purchases or
net sales in foreign exchange on a given day
have to be within their FEEL.

Physical intervention
Direct selling or buying of foreign exchange
by State Bank in the interbank 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.
Currently RBI only indirectly intervenes in the
market.

RESERVE BUILDING

Thank You

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