Foreign Exchange Market

By
Rajeev Kumar Jha

Treasury Department
Chinatrust Commercial Bank Ltd., New Delhi
Branch
 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
exchange”
Winston Churchill
House of Commons 1946

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 Structure of the Presentation

Basic Concepts, Terminologies, Instruments &

Mechanism.
Exchange Rate Regimes
Historical perspective
Foreign Exchange Trading & rate quotations
Role of Reserve Bank of India (RBI) in the FX
Market.
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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, traveler’s 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.

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

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 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. 48.50 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 12
ahead of the spot.
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 48.50
Sell One USD at 48.60
Spread 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 = 1.25%

Interest rate of INR = 6.00%
Spot Rate = 48.50
DB for INR = Actual/365
DB for USD = 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 customer’s 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 - $ 0.40

NET OPEN POSITION $ 1.00

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
 RBI’s 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.
 RBI’s 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 (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
Off Site monitoring of banks by RBI

 Reports from CRS Cont’d

Reports for research & statistical purposes

Types of transactions/customers/currency
Business volume - banks/customers/currency
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 it’s 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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