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General Bank Management(CAIIB)International Banking (Module A) PART-IForeign ExchangeTanushree Mazumdar, IIBF

Contents of Module AExchange ratesRisk management and basics of derivativesDocumentary letters of creditFacilities for exporters and importersCorrespondent banking and NRI accountsRBI and exchange control in India, EXIM Bank, ECGC

Exchange ratesInternational transaction in cash requires two distinct purchasesPurchase of foreign currencyPurchase of good/service with the FCTerm foreign exchange is used to denote foreign currencyForeign exchange market exists to cater to the demand for foreign currency/currencies

Foreign Exchange MarketOrganisational setting within which individuals, governments and banks buy and sell foreign currenciesOnly a small fraction of daily transactions in foreign exchange involve trading of currencyMost foreign exchange transactions involve transfer of bank deposits

Definition of foreign exchangeDeposits, credits and balances payable in foreign currencyDrafts, travellers cheques, letter of credit or bill of exchange expressed or drawn in Indian currency but payable in foreign currencyDrafts, travellers cheques, L/Cs, etc. drawn by banks, institutions or persons outside India but payable in Indian currencyThe above definition is as per FEMA (1999)

Exchange rate (1)Denotes the price or the ratio or the value at which one currency is exchanged for anotherExchange rate is very dynamicThe foreign exchange market is round-the-clock market due to different time zones Major participants- central banks, commercial banks, forex brokers, corporations, individuals

Factors affecting exchange rateMajor banks that act as market-makers always give two-way quotes; gives depth and volume to the marketFundamental reasonsTechnical reasonsSpeculation

Fundamental reasonsBalance of payments->surplus->appreciationGrowth rate of the economy-> higher growth->depreciation of currencyFiscal policy-> financing of fiscal deficit influences exchange rateMonetary policy->loose monetary policy-> depreciation of exchange rate

Technical reasonsFreedom or restrictions on capital movements can affect exchange rates to a large extentAmong other factors there are:Huge trade surpluses of oil exporting countriesCapital moving from low-yielding currencies to high yielding currencies (interest differential)

SpeculationSelf-fulfilling propheciesAnticipation of depreciation of a currency can cause dealers to sell that currencySpeculation serves to provide depth and liquidity to the forex marketActs as a cushion as well- contrarian traders exist in the market

Types of exchange rate (1)Ready/cash- Settlement of funds on the same day (date of the deal). Tom- Settlement of funds takes place on the next working day of the date of the dealSpot- Settlement of funds takes place on the second working day following the date of the deal

Types of exchange rate (2)Forward- Delivery takes place on any day after the date of the dealIn the forex market all rates that are quoted are generally spot ratesWhen delivery takes place beyond the spot date then it is a forward transaction and the forward rate is applicableForward rate = Spot rate + Premium (- discount)

Forward rateIf the forward value of a currency is higher than the spot value the currency is said to be at a premiumIf the above is reversed the currency is said to be at a discountThe forward premium/discount is based on interest rate differentials of the two currencies involvedDirect and indirect quotes of exchange rate- direct quote, local currency is variable

Quotes of Exchange RateCross rates- To obtain rates for a particular currency pair when they are not available directlyBid and offered rates- In USD/INR 39.40/41 the bank is bidding for USD at Rs. 39.40 and offering to sell USD at Rs. 39.41

Exchange ArithmeticAll foreign exchange calculations have to be worked with care and accuracy and several rules have to be kept in mindChain rule- is used to attain comparison or ratio between two quantities which are linked together through another or other quantities. Equation in the form of a chain is derived.Per cent and per mille- Per 100 units/per 1000 units

Example of a Chain Rule (1)Query: If we have to remit French Francs to France from India how do we go about it? (We have to arrive at cross rates between FRF and INR.)Mumbai interbank market:US $ 1 = Rs. 41.2550/2650London Market US $ 1 = FRF 6.0500/6.0550

Chain rule (2)At what rate can one buy FRF against rupees?How many Rs----- = FRF 1?FRF 6.0500 = US $ 1US $ 1 = 41.2650, therefore,FRF 6.0500 = US $ 1 = Rs. 41.2650Hence, FRF 1 = 41.2650/6.0500Or FRF 1 = Rs. 6.8206

Forward Rate (1)Value date: It is customary, in foreign exchange market, to quote a rate to do the deal but exchange the currencies not on the same day but generally afterwards.Forward rate: Has two componentsSpot rateForward points or forward differentials

Forward rate is the rate when the value of the deal is fixed beyond the spot date i.e. beyond the second working day after the deal

Forward Rate (2)Forward transactions are necessary in the foreign exchange market as they serve number of purposes like:One can hedge or cover an existing future financial, commercial or trade related exchange riskThese types of deals, in combination with spot deals, are used for money market operations through swap transactionsTaking a view of the market, these can be used for speculation

Forward rate (3)When a currency is costlier in the future (forward) as compared to the spot, the currency is said to be at a premium vis--vis another currencyIn direct rate premium is added to both the buying and selling rate whereas discount is deductedIn indirect rate premium is deducted and discount is added to the buying and selling rates

Forward rate (4)Base currency is the currency which is being bought and sold and the other currency is incidental.Forwards are quoted as followsSpot/1 month 17/18Spot/ 2 months 35/37Spot/ 3 months 53/56If forward differentials are in the ascending order (1st figure is lower than the 2nd) the base currency is at premium

Foreign exchange transactions (1)Arbitrage: Is an operation by which one can make risk free profit by undertaking offsetting transactions.Can be in interest rates: borrow in one centre and lend in anotherCan be in exchange rates: Buy a currency in one market and sell in anotherArbitrage keeps exchange rates uniform in all markets

Foreign Exchange Transactions (2)Merchant rates: Quotes offered to merchants (importers, exporters) by banks.Inter-bank rates: The rates quoted by banks for dealing in the inter-bank market.Merchant quotations: In India all merchant quotations for foreign currencies shall be in so many rupees for one unit of foreign currency except for Japanese Yen, Italian Lira and Belgian Franc (Rs/100 units of the currency)All quotes are in four decimal places with the last two digits in the multiple of 25

Modes of remittances (1)Telegraphic Transfers (TT) of funds are done from one centre to another by way of instructions through telex, telegram or SWIFT (Society for Worldwide Interbank Financial Transfer). Of late SWIFT is becoming popularMail Transfer (MT) of funds is done by way of instructions sent by mail. An MT is an order in writing on the correspondent bank/branch abroad to pay the beneficiary the sum mentioned

Modes of Remittances (2)Demand draft (DD): A DD is an order in writing on the correspondent bank/branch abroad to pay the beneficiary the sum mentioned therein.Fedai prescribed types of rates of merchant transactions:TT (buying)- clean inward remittancesBill (buying)- purchase/discount of export billsTT (selling) clean outward remittancesBill (selling) remittance for import bills

RBI/FEDAI Guidelines (1)RBI has issued Authorised Dealers (AD) licences to banks, all India financial institutions and a few co-operative banks to undertake foreign exchange transactions in IndiaIt has also issued Money Changer licences to a large number of established firms, companies, hotels, shops, etc.RBI/FEDAI Guidelines (2)Money changers help facilitate encashment of foreign currencies of foreign touristsEntities authorised to buy and sell foreign currency notes, coins and travellers cheques are called full fledged money changersThose authorised only to buy are called restricted money changersRBI/FEDAI Guidelines (3)FEDAI (Foreign Exchange Dealers Association of India) is a non-profit making body formed in 1958 with the approval of RBIIts members are authorised dealers and it prescribes guidelines and rules of the game for market operations, merchant rates, quotations, delivery dates, holidays, interest on defaults, etc.FEDAI also advises RBI on market related issues and supplements RBI on strengthening the market