CAIIB Super Notes: Bank Financial Management: Module A: International Banking: Exchange Rates and Forex Business

CAIIB – Super-Notes © M S Ahluwalia Sirf Business

Exchange Rates and Forex Business

Module A: International Banking

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CAIIB – SUPER NOTES

Bank Financial Management: Exchange Rates and Forex Business





Contents

Coverage:

1. Foreign Exchange – Definition

and Markets

2. Factors Determining

Exchange Rates

3. Exchange Rate Mechanism

4. Foreign Exchange Dealing

Room Operations

5. RBI/FEDAI Guidelines





FOREIGN EXCHANGE – DEFINITION AND MARKETS

1.





Foreign Exchange- Definition

• Conversion of currencies from the currency of invoice to the home

currency of the exporters – generally required for cross border

trade

• A For Ex Transaction is a contract to exchange funds in one

currency for funds in another currency at an agreed rate and

arranged basis.

• All claims payable abroad, whether consisting funds held in foreign

currency with banks abroad or bills, checks payable abroad.





For Ex - FEMA Definition

Foreign Exchange means foreign currency and includes:

i) All deposits, credits and balances payable in foreign currency, and

any drafts, traveler’s cheques, letters of credit and bills of exchange,

expressed or drawn in Indian currency and payable in any foreign

currency,

ii) Any instrument payable at the option of the drawee or holder

thereof or any other party thereto, either in Indian currency or in

foreign currency, or partly in one and partly in other.





ForEx Market Participants

• Central Banks

• Commercial Banks

• Investment funds/banks

• ForEx brokers

• Corporations

• Individuals





Foreign Exchange Markets

Characteristics:

• 24 hour market

• an over the counter market

• a global market with no barriers/no specific location

• supports large capital and trade flows

• highly liquid markets

• high fluctuations in currency rates

• settlements affected by time zone factor

• markets affected by governmental policies and controls





FACTORS DETERMINING EXCHANGE RATES

2.





Factors Determining Exchange Rates

Fundamental Reasons

Fundamental Reasons

Balance of Payment Balance of Payment

Economic Growth Rate Economic Growth Rate

Fiscal Policy Fiscal Policy

Monetary Policy Monetary Policy

Interest Rates Interest Rates

Political Issues Political Issues

Technical Reasons Technical Reasons

Freedom or Restriction of Capital Movement due to Govt. Controls

Freedom or Restriction of Capital Movement due to Govt. Controls

Movement to high yielding currencies Movement to high yielding currencies

Speculation Speculation

Provides depth and liquidity to the market and acts as a cushion

Provides depth and liquidity to the market and acts as a cushion





EXCHANGE RATE MECHANISM

3.





Types of Transactions

• Settlement of funds on the same day (t+0) Ready/Cash Ready/Cash

• Settlement of funds on the next working day (t+1) Tom Tom

• Settlement of funds on the second working day (t+2) Spot Spot

• Delivery of funds on any day after the spot date Forward Forward

• Date on which exchange of currencies actually takes place Value date





Forward Margins – Premium and Discounts

• Forward Rate = Spot Rate + Premium (or - Discount)

– Premium: Forward Value of Currency > Spot Value

– Discount: Spot Value of Currency > Forward Value

• In a perfect market, with no restriction on Finance and Trade, the

interest factor is the basic factor in arriving at the forward rate

• Forward price of a currency can be worked out on the basis of:

– Spot price of the currencies involved

– The interest rate differentials for the currencies

– The term, i.e., the future period for which the price is worked out





Type of Quotes

• Foreign currency expressed in terms of home currency (Local Currency is Variable)

• Also called Home Currency or Price Quotations

• Ex: USD 1 = Rs. 44.35

Direct Quote Direct Quote

• Home currency expressed in terms of foreign currency

• Ex: Rs. 100 = USD 2.25. Indirect Quote Indirect Quote

• Inter bank quotes Two-way Quotes Two-way Quotes

Internationally, all currencies other than GBP, Euro, AUD and NZD are quoted as direct rates.





Cross Rates

• When rates for a particular currency pair are not directly

available

• Ex:

– USD/INR Rate is 49.10/11

– GBP/USD Rate is 1.5000/10

– GBP/INR Rate will be: 49.10 x 1.5000/49.11 x 1.5010





Fixed vs. Floating Rates

• Fixed Rate: Official rate set by the monetary authorities for

one or more currencies

• Floating Rate: Value of the currency decided by supply and

demand factors

• The floating rate system is prevalent in the world market since

1973. India adopted the same in 1993.





Bid and Offered Rates

• Bid rate: Buying Rate

• Offered Rate: Selling Rate





Terminology

• 1 Per Mille: 1 part in every thousand

• Valuer Compensee payments: Where value date is same in

both centers

• Arbitrage:

– Simple/Direct Arbitrage: Between 2 centers only

– Compound/Three (or more) Point Arbitrage: Where additional centers

are involved





FOREIGN EXCHANGE DEALING ROOM OPERATIONS

4.





Functions

1. To meet requirements of customers of other

branches/divisions to buy or sell foreign currency.

2. Manage Foreign currency assets and liabilities.

3. Fund and manage Nostro accounts

4. Undertake proprietary trading in currencies.





3 Parts of a Dealing Room Fr

on

t O

ffic

e Fr

on

t O

ffic

e Dealing Room

Dealers who are actually involved in buying and selling the currencies, or undertaking market activities.

Dealing Room

Dealers who are actually involved in buying and selling the currencies, or undertaking market activities. M

id O

ffic

e M

id O

ffic

e Risk Management, and parametrization of Risks for forex dealing operations.

Compliance of guidelines and instructions.

MIS

Risk Management, and parametrization of Risks for forex dealing operations.

Compliance of guidelines and instructions.

MIS

Bac

k O

ffic

e B

ack

Off

ice Follow up and

Processing/Settlement of deals, Accounts, Reconciliation etc.

Follow up and Processing/Settlement of deals, Accounts, Reconciliation etc.





Positions

• Reflects inflow and outflow of funds i.e. receivables and payables.

• Mismatches between the two throw open interest rate Risks.

• Comprises of items that are both ready(immediate effect) and forward in nature

Funds Position Funds Position

• Deals with overbought or oversold positions.

• The overall net position exposes the dealer to exchange Risks from market movements.

Currency Position Currency Position





Terminology

Exchange Position/Position

• The difference between the amount of a currency bought and the amount of the same currency sold is known as “position” in that currency.

Exchange Position/Position

• The difference between the amount of a currency bought and the amount of the same currency sold is known as “position” in that currency.

Overbought Position

• If the amount of FC bought by a bank is more than the amount sold, the difference between the two is “Overbought/Long/Plus” position

Overbought Position

• If the amount of FC bought by a bank is more than the amount sold, the difference between the two is “Overbought/Long/Plus” position

Oversold Position

• If the amount of FC sold by a bank is more than the amount bought, the difference between the two is “Oversold/Short/Minus” position.

Oversold Position

• If the amount of FC sold by a bank is more than the amount bought, the difference between the two is “Oversold/Short/Minus” position.

Square Position

• If the amount of FC bought by a bank equals the amount sold, then the bank is said to have “square” position. If there is a small difference, it is known as “Near Square position”

Square Position

• If the amount of FC bought by a bank equals the amount sold, then the bank is said to have “square” position. If there is a small difference, it is known as “Near Square position”

Open Position

• Exchange position at given point of time

Open Position

• Exchange position at given point of time

O/N Position

• Open Exchange position at the end of the day

O/N Position

• Open Exchange position at the end of the day





Major Risks associated with ForEx Dealing Operations

Operational Risk

Operational Risk

Exchange Risk Exchange Risk Credit Risk Credit Risk Pre-

settlement Risk

Pre-settlement

Risk

Settlement Risk

Settlement Risk

Liquidity Risk Liquidity Risk Gap

Risk/interest rate Risk

Gap Risk/interest

rate Risk Market Risk Market Risk

Legal Risk Legal Risk Systemic Risk Systemic Risk Country Risk Country Risk Sovereign Risk Sovereign Risk





RBI/FEDAI GUIDELINES

5.





Categorisation of Authorised Persons

Cat 1 Cat 1

• Authorised Dealer Banks

• Financial Institutions

• Other entities permitted to handle all types of ForEx transactions

• Earlier known as Authorised Dealers

Cat 2 Cat 2

• Money Changers authorised to undertake sale/purchase of FC notes, travellers cheques, handle FC transactions relating to remittance facilities.

• Earlier known as Full Fledged Money Changers (FFMCs)

Cat 3 Cat 3

• Allowed to undertake only purchase of FC notes and traveller’s cheques

• Earlier known as Restricted Money Changers (RMCs)





FEDAI Guidelines/Rules

1. Standard transit period for export bills

2. Crystallisation of bills in foreign currency in case of delay in realisation

within 60 days

3. Sight bills for Import LC would crystallise on 10th day after date of receipt

4. Forward contracts to have definite amounts and specific delivery dates

5. Delivery period under option contract shall not exceed one month

6. All forward contracts to be automatically cancelled on the 7th working

day after maturity if not picked up

7. All cancellation at Bank’s opposite TT rates





FEDAI Guidelines/Rules

8. Interest @ 2% above the prime rate of the currency to be charged in

event of delay in payment of interbank foreign currency funds

9. Interest @ 2% above the NSE MIBOR to be charged in event of delay in

payment of rupee settlement funds

10. All currencies to be quoted as:

– Per unit of Foreign currency =INR. Ex: $1 = Rs 45.67

– Except JPY, Indonesian Rupaih and Kenyan Schilling. To be quoted as 100 units of

Foreign currency = INR.

FEDAI also prescribes code of conduct for FOREX dealers, as also guidelines with regard to dealings with forex brokers.





RBI Guidelines

• Guidelines related to:

– Open positions

– Gaps

– Borrowing and Lending in Foreign currencies

– Interbank dealings in India and overseas markets

– Hedging of bank’s own exposures as well as that of its resident and

non-resident clients





RBI Guidelines

1. AD CAT 1 Banks allowed to open/close rupee accounts

1. In names of overseas branches or correspondents without prior reference to RBI

2. In names of exchange houses with prior reference to RBI

2. AD CAT 1 Banks allowed to open/close foreign currency accounts abroad

3. AD CAT 1 Banks can undertake investments in overseas markets in money

market instruments and/or debt instruments, issued by foreign state,

maturity < 1 yr, rated as per guidelines

4. Surplus funds in Nostro accounts can be used for

1. Granting Loans to resident constituents

2. Extending credit facilities to Wholly Owned Subsidiaries/JVs of Indian companies

abroad





RBI Guidelines

5. All borrowings in Nostro accounts (including ECB and Temp. Overdraft) not

adjusted within 5 days shall not exceed 50% of their unimpaired Tier 1 Capital

or USD 10 million whichever is higher

6. Banks can allow banks to book Forward Exchange contracts to hedge their

exchange risk exposure

- The genuineness of the underlying documentary evidence and exposure must be

ascertained

7. Banks can allow importers/exporters to book Fwd. Contract on basis of

declaration of the exposure with limit based on past performance

8. SME customers may be allowed to book forward contracts in alignment with

the credit facilities availed by it from the bank





RBI Guidelines

9. Banks can allow resident individuals to book Forward contracts on

deliverable basis with tenors up to 1 year up to a limit of USD $ 100,000.

10. Banks can offer other derivative contracts to resident entities who have

borrowed foreign exchange in accordance with the provisions of FEMA

1999

11. Banks can also offer Foreign currency Rupee Swap to resident entities

that have a forex or rupee liability to hedge long term exposure

12. Banks can enter into cross currency options and foreign currency-rupee

options with their customers on back to back basis





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Documents

CAIIB Super Notes: Bank Financial Management: Module A: International Banking: Exchange Rates and Forex Business