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PILLAI INSTITUTE OF MANAGEMENT STUDIES AND
RESEARCH
Course Syllabus&
Study Notes
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Post Graduate Diploma in Management –
IB/BFM
Semester III
FOREX MANAGEMENT
Prof. D. C. Pai
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Syllabus
UNIT 1
THE HISTORY OF MONEY
HOW DID MARKETS FUNCTION WITHOUT COINS AND PAPER MONEY? BARTER AND ANCIENT TRADE THE LIMITS OF BARTER THE DEVELOPMENT OF CURRENCY THE FUNCTIONS OF CURRENCY
UNIT 2
THE GLOBAL FOREIGN EXCHANGE MARKET
FOREIGN EXCHANGE TURNOVER SPECULATION IS THE KEY DRIVER FOREIGN EXCHANGE MARKET CHARACTERISTICS REGULATION FOREIGN EXCHANGE MARKETS – SUM UP. LEADING CURRENCIES CURRENCY TRADING TRENDS CURRENCY AS AN ASSET CLASS SUMMARY
UNIT 3
EXCHANGE RATES AND THEIR MOVEMENTS
INTRODUCTION/DEFINITION. FACTORS DETERMINING EXCHANGE RATES CURRENCY MOVEMENT FACTORS THE IMPACT OF REAL INTEREST RATES SPECULATION AND OTHER FACTORS
UNIT 4
EXCHANGE RATE MECHANISM
Types and Calculation READY OR CASH, TOM, SPOT, VALUE DATE SPOT AND FORWARD RATES DIRECT AND INDIRECT QUOTES
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CROSS RATES & CHAIN RULE FIXED VS. FLOATING RATES ARBITRAGE IN EXCHANGE
UNIT 5
FOREIGN EXCHANGE DEALING ROOM OPERATIONS
QUALITIES OF A DEALER FUNDS POSITION, CURRENCY POSITION FRONT OFFICE, BACK OFFICE & MID OFFICE MANAGEMENT AND CONTROL OF DEALING ROOM RISK ASSOCAITED WITH FX DEALING ROOM
UNIT 6
RISK IN FOREIGN EXCHANGE OPERATIONS
INTRODUCTION DEFINITIONS OF RISK AND RISKS IN INTERNATIONAL TRADE RISKS IN FOREIGN EXCHANGE OPERATIONS WHAT IS RISK AND VARIOUS RISKS IN INTERNATIONAL TRADE MANAGEMENT OF THESE RISKS AND VARIOUS GUIDELINES RELATED TO RISK MANAGEMENT
UNIT 7
BASICS OF DERIVATIVES
WHAT ARE DERIVATIVES HISTORY AND DEVELOPMENT DERIVATIVES IN INDIA — AN OVERVIEW DERIVATIVE INSTRUMENTS FORWARD CONTRACTS
UNIT 8
DERIVATIVE INSTRUMENTS - FUTURES
FUTURES – KEY FEAUTRES FUTURES VS FORWARDS THE MARGIN PROCESS
O INITIAL MARGINO VARIABLE MARGINO MAINTAINCE MARGIN
UNIT 9
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DERIVATIVE INSTRUMENTS - OPTIONS
OPTION ISA RIGHT NOT AN OBLIGATION CALL OPTION / PUT OPTION OPTION PREMIUM IN THE MONEY, AT THE MONEY, OUT OF THE MONEY AMERICAN OPTION/ EUROPEAN OPTION
UNIT 10
DERIVATIVE INSTRUMENTS - SWAPS
INTEREST AND CURRENCY SWAPS DEFINITION COMPARITIVE ADVANTAGE ASSET AND LIABILITY MANAGEMENT INTEREST RATE SWAPS CURRENCY SWAPS
UNIT 11
Hedging FOREIGN EXCHANGE RISK
INTRODUCTION HEDGEING HEDGEING INSTRUMENTS
O SHORT TERM HEDGEINGO LONG TERM HEDGEING
SPECULATION ARBITRAGE
UNIT 12
REGULATORY FRAMEWORK
REGULATORY FRAMEWORK THE RESERVE BANK OF INDIA FOREIGN EXCHANGE DEALER’S ASSOCIATION OF INDIA IMPORTANT REGULATORY GUIDELINES FOR
O RESIDENTS OTHER THAN AD’SO FOREIGN INSTITUTIONAL INVESTORS (FII)O NON RESIDENT INDIANS & OVERSEAS CORPORATE BODIESO FOREIGN DIRECT INVESTMENTS (FDI)O FOREX FACILITIES FOR RESIDENTS (INDIVIDUAL)
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UNIT 1THE HISTORY OF MONEY
Learning objectives:
After studying this unit, you should be able to:
HOW DID MARKETS FUNCTION WITHOUT COINS AND PAPER MONEY? BARTER AND ANCIENT TRADE THE LIMITS OF BARTER
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THE DEVELOPMENT OF CURRENCY THE FUNCTIONS OF CURRENCY
BARTER AND ANCIENT TRADE
HOW DID MARKETS FUNCTION WITHOUT COINS AND PAPER MONEY?
The concept of barter is familiar to all of us. For instance, a babysitter could exchange her services for a couple of tickets to a rock concert. Or a bachelor might get his elderly neighbor to mend his shirts and trousers in exchange for mowing her lawn. In both cases, no money changes hands. The Oxford English Dictionary defines barter as “to trade by exchanging goods and services for other goods and services, not for money. It is probably the oldest way of conducting business and predates use of coins and paper money. But as implied by the examples above, bartering is still common in the present day.
Historians trace the origins of barter to the early Stone Age period between 8000 BC and 6000 BC, in settlements in the Middle East, Greece and Turkey, as well as in many parts of Asia and Africa. Before this time, humans mainly subsisted by hunting and gathering food. They had to be self-sufficient to keep from starving and this encouraged a nomadic existence as they sought new areas in which to forage. Sometimes they may not have been compelled to trade, perhaps taking what they wanted from rival groups of hunter-gatherers by force, rather than negotiation, if the situation arose. The hunter-gatherer way of life started to wane during the Neolithic period, when people first learned to cultivate crops and make a variety of basic tools. They began to domesticate animals, such as cattle, sheep, and camels, as sources of food and to work on their farms. As a store of value, these domesticated animals became items for barter. Farming, animal
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domestication, and trade allowed people to settle in fixed locations and develop greater food productivity. This, in turn, led to accelerated population growth, and consequently, translated into more mouths to feed.
These nascent agrarian communities faced many problems. Climatic events such as droughts or flooding would have severely damaged or depleted crops. But as communities adapted to a variety of environmental conditions, they may have been able to achieve surpluses of crops and produce. These could have been stored to help sustain those communities over longer periods, such as the winter months, or they could have been exchanged for other goods or produce. In this way, bartering developed as people would trade their surplus goods for items they did not grow or make. Bartering may have started within the communities themselves, gradually expanding to embrace other settlements and cultures.
We can make some inferences about how people bartered in those early days. Let’s look at two theoretical communities. One of them was good at rearing cattle while the other became adept at growing wheat. These two communities may have bartered wheat for cattle, if they were able to find each other. The exchange of goods would have been smooth if each community got what it wanted. Therefore, they had to decide what a fair exchange of goods was. This quantum of exchange was hard to determine as it varied with different counterparties and between different regions. For instance, how much would one cow have been worth in terms of bags of wheat? This would have depended on how the two parties valued their own wheat and cattle against the wheat and cattle of other community and how badly they needed what the other party had. To make matters worse, communication problems
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would have also existed between different peoples. Nonetheless, agreements were definitely reached because the barter system started to thrive during the Neolithic period.
THE LIMITS OF BARTER
Indeed, bartering worked as long as people had goods that other people needed and vice versa. But there were problems with this system. What if a person or a community had something to trade that one else wanted? Or what if the terms for a fare transaction could not be agreed upon? The limitation of barter trade probably became more evident as communities started to interact over greater distances.
We know that the paths taken by the people from one area to another, for trade purposes, were gradually transformed into a network of trade routes connecting larger and more distant areas. These routes such as the Incense route stretching from Egypt, through Arabia, to India and the Spice Route from Portugal, around Africa, to India, linked great civilizations. Probably the best known of these ancient trade routes is the Silk Road that connected China with the Mediterranean region. This was a single road but a series of interconnected routes, especially as it passed through Central Asia. Not only was silk traded on it, but also other goods such as grain, gold, rubies, opium, pearls and jade. The Silk Road was immortalized by Venetian explorer Marco Polo in the book, The Travels of Marco Polo, written in the thirteenth century. But by then, barter trade had long been superseded by the use of money. How and why did this happen?
THE DEVELOPMENT OF CURRENCY
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There were several reasons for replacing barter trade, some of which we have already alluded to. For barter to successfully take place, there has to be what is termed by economists a “double coincidence of wants”—that is, Mr. A must want what Mr. B has and Mr. B must simultaneously want what Mr. A has. Finding someone else whose immediate needs exactly complement one’s own can be costly in terms of time and effort. Imagine transporting your goods to marketplace miles away from your home only to find that no one is interested in what you have to barter. This may have been the reality for many people during the Neolithic period, who would have had to return to their communities disappointed in addition, the risk of damage or robbery when traveling beyond your own clan or community would have made barter increasingly unappealing.
To overcome the problems surrounding barter, the great early civilizations, who thrived on trade, gradually developed alternative means of exchange. Common barter commodities, such as wheat, for which there would always be demand, were standardized into weights and measures which, in turn, helped to value other goods and services by using those terms. But, as mediums of exchange, the use of such commodities was still limited since the cost of transporting them was high. Therefore, a “medium of exchange” that could be carried around easily and was broadly recognized as having value was required. Also, once received, people could use these mediums of exchange to buy other goods. This was the origin of what we now call “currency” or “money.”
THE FUNCTIONS OF CURRENCY
It is useful to map out the key functions of money as we know them now. This will give us a better insight into the motivations governing the development of coins and paper money. Historically, money has had three essential functions:
• Medium of exchange: Money is used so that goods and services can be exchanged easily.
• Measure of value: Money is used to let people fairly assess the comparative worth of different goods and services.
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• Store of value: Money can be reliably saved without spoiling and used at a later date with predictability.
On the basis of these three key functions, money developed the following distinct characteristics:
• Convertibility• Portability• Divisibility• Durability• Stability of value
These characteristics were already evident in the earliest coins recorded in our history. If we look at these functions in terms of a wheat-for-cow barter trade, we can see why a money trade was easier than bartering. Wheat may have been a better medium of exchange than cattle, but it also had its portability limits. As a measure of value, it may have been difficult to consistently assess the comparative worth of wheat and cattle. For instance, some cattle may have been bigger than others, while certain types of wheat may have drawn strong demand from some people, but not from others. As for a store of value, how long could a cow be kept before its value dropped due to ageing? Also, what was the use-by date for wheat before it became mouldy and carried no value at all? Divisibility would be a problem as it would be impossible to divide a cow into equally valued parts. Durability was an issue for both wheat and a cow since one could vanish with a flame while the other would age or die. Coins were an obvious alternative.
Trade originally functioned without money in the form of coins and paper, with many different forms of currency being used ranging from cattle to cowries shells to beads and jade. Historians trace the origins of barter to the Neolithic period in the settlements between 8000 BC and 6000 BC in the Middle East, Greece and Turkey, as well as in many parts of Asia and Africa. The popularity of barter trade was eventually superseded by transactions involving coins and paper money. For barter trade to successfully take place, there has to be what is termed by economists a “double coincidence of wants”—that is, Mr. A must want what Mr. B has and Mr. B must simultaneously want what party A has. Thus, a key
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motivation for this shift was that people needed mediums of exchange that were easier to transport and more widely accepted. Coins first struck in the region of Lydia, now in modern-day Turkey. From Lydia, electrum coinage spread to the cities of coastal Asia Minor like Byzantium, Chalcedon and present-day Kinik in southwestern Turkey. From there, it reached the Greeks of the islands and the mainland. The coinage of the Lydian’s had been in existence for more than a millennium when paper money first emerged in China under the Tang Dynasty (618 AD—907 AD). The early development of paper money continued during the Song Dynasty (960 AD—1279 AD). It was further developed in Europe in the centuries that followed. Still, the early history of money remains cloudy with new views about the origins of money regularly being put forward by historians.
The origins of modern-day financial centers were the late 17th century humble coffee houses of London, where people of all commercial persuasions would meet and information would be exchanged on areas of commerce finance and shipping. Many of these coffee shops were located close to the Royal Exchange, a mercantile hub set up by English merchant and financier Sir Thomas Gresham late in the 16th century. Apart from his association with the Royal Exchange, Gresham is also known for an economic theory called Gresham’s Law, though he is not believed to have put forward the theory himself. It was more an observation he had made. Meanwhile, early information lists supplied by publicans helped to develop a thirst for more of such information. It is known that the Lloyd’s List contained information about exchange rates as did lists made by coffee house proprietors that were geared toward stocks. Against this backdrop, one of the longest-surviving companies of all time, the East India Company, was at the heart of the expansion of global trade from the 17th century. It is said that without this company, there would have been no British empire. The money that helped fuel global trade had been backed against different standards like silver and gold through the ages. The advent of the foreign exchange markets as we know them today came soon after the gold standard was finally abandoned by U.S. President Nixon in 1971. This precipitated the collapse of the Bretton Woods agreement signed in July 1944.
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Key learning :
o Barter: To trade by exchanging goods and services for other goods and services, not for money
o Foreign Exchange: Exchange of one currency into another.
o Rate of exchange: The price of one currency in terms of another or a simple arithmetic expression of value of one currency in terms of another currency
o Foreign Exchange Market: The market where foreign currencies are dealt with.
o OTC Market: Over the counter market
UNIT 2
THE GLOBAL FOREIGN EXCHANGE MARKET
Learning objectives:
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After studying this unit, you should be able to:
FOREIGN EXCHANGE TURNOVER SPECULATION IS THE KEY DRIVER FOREIGN EXCHANGE MARKET CHARACTERISTICS REGULATION FOREIGN EXCHANGE MARKETS – SUM UP. LEADING CURRENCIES CURRENCY TRADING TRENDS CURRENCY AS AN ASSET CLASS SUMMARY
FOREIGN EXCHANGE TURNOVER
It is easy to say that the foreign exchange market is the world’s most important financial market. The rapid increase in world trade and investment that we have witnessed in recent years means that the exchange of different currencies has accelerated. According to the Bank for International Settlements’ (BIS) April 2004 “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity,” average daily international foreign exchange trading volume was almost US$1.9 trillion. That foreign exchange trading survey collected national foreign exchange and derivatives market data from 52 central banks and monetary authorities around the world. BIS said in its report: that the growth in turnover was driven by all types of counterparties, with trading between banks and financial customers rising most strongly. The report noted that foreign exchange turnover among banks and their financial customers rose because of the increase in activity of hedge funds and commodity traders, as well as robust growth in trading by asset managers. This contrasts with the period between 1998 and 2001, when activity in this market segment had been driven mainly by asset managers, while the role of hedge funds had reportedly declined. Foreign exchange turnover grew strongly between 1989 and 2001, and then took a dip in 2001, before surging again in 2004. The decline in 2001 was partly attributed to the advent of the euro in 1999, which saw the end of trading in important currencies like the Deutsche mark and the French franc. Another reason cited was rationalization in the global banking sector in the wake of the Asian financial crisis in 1997 and the bursting of the dot.com bubble in early 2000.
In 2006, the average daily turnover on the New York Stock Exchange was estimated at about US$90 billion, while the trading volume in foreign exchange, at US$1.9 trillion per day, was more than 10 times
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the average daily turnover of all the world’s other stock markets. Considering that the free- floating currency system, which is at the center of foreign exchange trading, only began in the 1970s, the daily trading figure is staggering. And trading volumes are growing robustly. It is estimated that the average daily volume in global foreign exchange could soon reach as high as US$3 trillion.
SPECULATION IS THE KEY DRIVER
The most important component of daily trading volume is speculative activity—this usually relates to global capital seeking the most profitable return in the shortest period of time. It is estimated that 95% of foreign exchange transactions are speculative. More than 40% of trades last less than two days, while about 80% of trades last less than one week. In December 2004, the BIS published a follow-up report to its triennial survey of April, titled “Why has FX trading surged? Explaining the 2004 Triennial Survey.” The report confirmed that the surge of activity between banks and financial customers could reflect the broad search for yield that has characterized financial markets in recent years. It noted that, in this search, currency market players worldwide have followed two key strategies—one is based on interest rate differentials and the other on trends in exchange rates. The report said: “The first strategy exploited the forward bias by investing in high-yielding currencies. A popular form of this investment strategy among leverage players and real money managers was the so-called carry trade.” In a “carry trade,” an investor borrows in a low interest rate currency and, with these funds, takes a long position (buys) in a higher interest-rate currency betting that the exchange rate will not change so as to offset the interest rate differential between the two currencies. “While U.S. dollar depreciated and the interest rate differential persisted, such investment strategies were profitable and a likely factor contributing to turnover growth,” it said. The second strategy involved “momentum trading,” where investors took large positions in currencies aimed at exploiting long swing or runs in exchange rates such trades added weight to the underlying trends in exchange rates between countries. “Following the April 2001 survey, there was a strong pattern of U.S. dollar depreciation as the price of a dollar in different major currencies fell steadily until early spring 2004. U.S. dollar depreciation ranged from about 15% against the Canadian dollar and Japanese yen, to more than 30% against the Australian dollar.” Beyond the position-taking related to profit opportunities associated with exchange rate trends, the report said such runs may also be associated with growth in hedging-related turnover. “Multinational firms face greater incentives to hedge in the face of long swings in currencies in order to minimize losses associated with currency positions. For instance, the European exporter invoicing in dollars in the midst of a long run of dollar depreciation has an incentive to hedge against further depreciation,” it added.
FOREIGN EXCHANGE MARKET CHARACTERISTICS
In recent years, the three major foreign exchange markets have been London, New York, and Tokyo. According to the 2004 BIS survey the U.K. and U.S. accounted for more than 50% of daily turnover, while Japan accounted for slightly more than 8%. Singapore was also an important player with about 5% of the average daily turnover (see Figure below).
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Although we identify the countries where foreign exchange trading takes place, this trading is distinct from equities market or commodities market insofar as foreign exchange markets have no fixed locations.
Average Daily Turnover by Country
Country Share
United Kingdom 31.3%
United States 19.2%
Japan 8.3%
Singapore 5.2%
Germany 4.9%
Hong Kong 4.2%
Australia 3.4%
Switzerland 3.3%
France 2.7%
Canada 2.2%
Others 15.3%
Total 100%
Source: Bank of International Settlements Triennial Survey 2004
Foreign exchange markets are actually decentralized over the counter markets that cut across borders. They are also the least regulated of all financial markets. Here are some of the commonly cited characteristics of the foreign exchange markets:
24-Hour Market: The currency market doesn’t sleep during the working week and players can enter or exit trading positions at any time. There is no opening bell as the global trading day starts in Wellington, New Zealand, moves westward via Sydney, Tokyo, and Singapore, then Moscow, Frankfurt, London, and finally New York and San Francisco, before starting a new global day in Wellington again. Traders can, therefore, effectively choose when they want to trade morning, noon, or night.
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Liquidity: The foreign exchange market has better depth and breadth than any other capital market. Financial instruments like stocks and commodities are all subject to what is available in an order book and investors may not get all they want in one go. A foreign exchange order has the potential to be filled instantaneously at one rate and in a good size.
Easy Entry: Anyone who wishes to trade in currencies can do so by using any of a number of companies to set up online trading accounts that operate around the clock.
Simple Trading Decisions: Only a few of the world’s currencies represent the bulk of the average daily turnover. This is in contrast to thousands of stocks to choose from in the world’s stock markets. As such, the decision to buy or sell can be reached more quickly.
Neutral Conditions: Currencies trade in pairs and typically one side of every currency pair constantly moves relative to the other side. When you buy a currency, you are simultaneously selling the other currency in the pair. So, if some currencies go up, others have to go down. There’s no structural bias and profits can be made as currencies go up or down.
High Leverage Possible: Participants can typically leverage their positions to as much as 100 times the cash they put up. This means that the foreign exchange market trader need only deposit US$1,000 for each US$100,000 position traded. This makes currency trading accessible to a wider range of traders because the initial funds requirement is very low relative to the size of the trading positions they hold. But the risks are commensurate—if a bet goes wrong, they can lose by a correspondingly high amount.
Low Transaction Costs: Transaction costs are normally lower in the foreign exchange market and currencies are cheaper to trade than stocks. Foreign exchange trading is typically commission-free and there is no exchange or clearing fees. Thus, bottom line visibility is clearer for traders, making decisions about taking new trading positions, or what to do with existing ones, quicker and more efficient.
Tight Bid-Ask Spreads: Because of the high liquidity within the currency market, bid-ask spreads are generally tighter when compared with bonds, equities or futures. The spread reflects transaction costs in the foreign exchange market.
Real-Time Quotes, Instant Execution: Players in the foreign exchange market can execute their trades directly off real-time bid-ask quotes. This means that trades can be executed with much more certainty than, for example, transactions that have to be executed on an exchange floor.
Against this backdrop, the dynamic nature of the foreign exchange market is an attractive proposition to many investors. As is the case with any type of investment vehicle, there are risks and rewards in currency trading. These risks and rewards are amplified in the foreign exchange market because it is relatively unregulated. For instance, a stock exchange is a highly regulated environment, with tight rules
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placed on buying and selling. This helps to keep the playing field fair for everyone and takes away, for example, the opportunity for companies to manipulate stocks for their own ends. While the potential for a skilled investor to realize significant profits in the foreign exchange market is large, good investors will also familiarize themselves with potential downside risks, which can be magnified by margin trading.
REGULATION
Each foreign exchange transaction comes with its own associated risks, including volatility, exchange rate risk, credit risk, monetary risk, and interest rate risk, as well as the possibility of central bank intervention. Because the foreign exchange market is largely unregulated on an international scale, trading activity is generally subjected to lows and customs of each participants home nations.
FOREIGN EXCHANGE MARKETS – SUM UP.
Foreign exchange markets comprise individuals, business entities, banks, investors, users and arbitrageurs, across the globe, who buy or sell currencies. It is a communication system-based market, with no boundaries, and operates round the clock, within a country or between countries. lt is not bound by any four-walled marketplace, which is a common feature for commodity markets, say vegetable market, or fish market.
Forex markets are dynamic and round the clock market, due to different time zones in which various countries are located. Geographically, forex markets extend from Tokyo and Sydney in the east, through Hong Kong, Singapore, Bahrain, London and New York in the west.
If we view the markets as per GMT, when the London and other European markets start the day it is almost lunch time for the Indian markets, and when the Indian markets are about to close, the New York market is about to begin its day. While the New York market operates for sometime alongside the London and European markets, the markets in the east, Tokyo, Hong Kong and Singapore are ready to start, before New York closes. Thus the clock has turned around, with Indian and Middle East markets ready to start the day, before close of Singapore and Hong Kong markets.
The world currency markets are a very large market, with a large number of participants. Major participants of forex markets are:
Central Banks — managing their reserves and using currency markets to smoothen out the value of their home currency.
Commercial Banks — offering exchange of currencies to their retail clients and hedging and investing their own assets and liabilities as also on behalf of their clients, as also speculating on the movements in the markets.
Investment funds/banks — moving funds from one country to another using exchange markets as a vehicle as also hedging their investments in various countries/currencies.
Forex brokers — acting as middleman, between other participants, and at times taking positions on their books.
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Corporations— moving funds between different countries and currencies for investment or trade transactions.
Individual — ordinary or high net worth individuals using markets for their investment, trade, personal, and travel and tourism needs.
As seen above, the participants not only use the forex markets for trade or travel purposes, but also for investments, hedging and speculative purposes, thus generating large volumes for the market. It may be surprising for some of the readers that the global forex market handles total turnover of approx. US dollar 1.90 trillion per day. This is against daily world trade turnover of approx. US dollar 750 billion per day, thereby meaning that more than 98% of the global forex trading relates to investments, or speculative trading. The Indian markets, trade US dollar 1.20 billion per day, mostly because of regulatory exchange control regime and restrictive flow of foreign currency. The forex markets are highly dynamic, that on an average the exchange rates of major currencies (say GBP/USD) fluctuate every four seconds, which effectively means it registers 21,600 changes in a day (15x60x24). Forex markets are usually Monday to Friday markets globally, except for Middle East or other Islamic countries which function on Saturday and Sunday with restrictions, to cater to the local needs. The bulk of the forex markets are OTC (over the counter) markets, meaning that the trades are effected through telephone or other electronic systems (dealing systems of various news agencies, banks, brokers or Internet-based solutions).
Banks in London quite commonly deal with banks in Paris, Frankfurt, Mumbai and New York and even in Tokyo or Singapore, which are totally in a different time zone. Large dealing rooms operate round the clock, to be with all major markets across the globe. For a few traders, systems are provided in bedrooms too, to enable them to trade in any time zone. Major banks, which act as market makers always quote two way quotes, (buy and sell), and leave upon the caller to either buy or sell as per his needs. This generates market depth and volumes. Thus characteristics of foreign exchange market can be listed as under:
A 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 (every 4 seconds) Settlements affected by time zone factor Markets affected by governmental policies and controls
LEADING CURRENCIES
The four most important currencies in foreign exchange markets in terms of trading volume, are the US dollar, the euro, the Japanese yen, and UK pound sterling (see Figure 5.4).
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The International Organization for Standardization (ISO) has assigned the following codes to the four main currencies: USD, EUR, JPY, and GBP respectively. Generally, the currency code is composed of the country’s two- character country code plus an extra character to denote the currency unit. After the USD, EUR, JPY, and GBP, the next most heavily traded currencies in the world are the Swiss franc (CHF), the Canadian dollar (CAD), the Australian dollar (AUD), and the New Zealand dollar (NZD).
As we have noted, currencies trade in pairs in the foreign exchange market. This involves simultaneous buying one currency and selling another currency. The most important currency pairs are EUR/USD, USD/JPY, GBP/USD, and USD/CHF. USD/CAD, AUD/USD, and NZD/USD are known as the “dollar Bloc” currencies. These currency pairs are referred to as “majors,” which distinguish them as the most liquid and widely traded currency pairs in the world. Trades involving majors are estimated to make up about 90% of all trading in foreign exchange markets. EUR/USD is the most actively traded pair, accounting for almost 30% of global average daily turnover. The next two most important pairs in terms of daily turnover are USD/JPY and GBP/USD.
Note that there is a system to the way that currency pairs are quoted. The first currency in the pair is considered the base currency and the second currency is the quote currency or counter currency. For example, the euro is the base currency and the U.S. dollar is the quote currency in the EUR/USD pair. Or for USD/JPY, the U.S. dollar is the base currency while the Japanese yen is the quote currency. Most of the time the US dollar acts as the base currency. Quotes are expressed in units of US$1 per quote currency.
CURRENCY TRADING TRENDS
The BIS triennial survey of 2004 revealed some interesting global trends, in terms of currency and geographical share of turnover, compared to the previous survey in 2001. As mentioned, the EUR/USD was the most widely traded currency pair, averaging US$501 billion per day or 28% of total turnover (see Figure below). However, the share of the EUR/USD was slightly down from 30% in 2001. This was attributed to factors including an investors’ drive for diversification into a wider range of currencies, to seek better returns on their investments, and greater demand for hedging in a wider range of currencies by companies exposed to different foreign currencies. The second most actively traded currency pair was the USD/JPY, with 17% of turnover or US$296 billion per day.
Figure — Average Daily Turnover by Currency Pair, 2004
Country Share
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EUR/USD 28%
USD/JPY 17%
GBP/USD 14%
AUD/USD 5%
USD/CHF 4%
USD/CAD 4%
EUR/JPY 3%
EUR/GBP 2%
ELJRICHF 1%
Others 22%
Total 100%
Source: Bank of International Settlements
Triennial Survey 2004
In terms of individual currencies, the U.S. dollar was the most heavily traded with 88.7% of average daily turnover followed by the euro at 37.2% (see Figure below). Both were a tad below their shares from the 2001 survey, which were 90.3% and 37.6% respectively.
Figure Average Daily Turnover by Currency, 2004
Country Share
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USD 88.7%
EUR 37.2%
JPY 20.3%
GBP 16.9%
AUD 6.1%
CHF 5.5%
Source: Bank of International Settlements Triennial Survey 2004
The share of the yen was also down, from 22.7% to 20.3%, with the pound taking up some of the slack with a 16.9% share of turnover, up from 13% in 2001. The Swiss franc maintained its position from 2001 at 6.1%, while the Australian dollar’s share rose to 5.5% from 4.2% in 2001. (Note, the total share exceeds 100% due to double counting or more on currency pairs.)
CURRENCY AS AN ASSET CLASS
The surge in foreign exchange trading signifies a growing recognition that currencies are an asset class in their own right. In “Why has FX Trading Surged?” Explaining the 2004 triennial survey, authors Gabriele Galati and Michael Melvin noted the attractiveness of currencies, compared to bonds and stocks, in inventors’ search for yield. They said that interest in currencies as an asset class was reinforced by disappointing yields in stock and bond markets at different times. As returns on stocks and bonds waned, investors found currency strategies to be quite profitable over the 2001 to 2004 period. Following the 2001 survey, there was a long run of dollar depreciation that was actively exploited by investors. It can be seen that, in general, at that time equity markets were falling well into 2003 before beginning an upward run that lasted less than a year. Bond yields were low and fairly flat over the period. So, the strong trend in the foreign exchange market offered an attractive alternative to stocks and bonds.
Thus, the major attraction of currencies as an asset class is for portfolio diversification since their movements are often uncorrelated to other asset classes.
Summary
Foreign exchange trading volumes are collated once every three years by the Bank for International Settlements. Its triennial survey for 2004 showed the staggering extent of the foreign exchange trading—then at $1.9 trillion a day—and by most accounts trading volumes have grown since then. Growth has been driven by hedge funds, central banks and other investors, adding to the liquidity already provided by commercial and investment banks. It should be stressed that the most important component of daily trading volume is speculative activity – this usually relates to global capital seeking the most profitable return in the shortest period of time. It is estimated that 95% of foreign exchange transactions are speculative. In recent years, the three major foreign exchange markets have been London, New York
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and Tokyo. According to the Bank for International Settlements’ triennial survey for 2004, the U.K. and U.S. accounted for more than 50% of the daily turnover, while Japan accounted for slightly more than 8%. Singapore was also an important player with about 5% of the average daily turnover. The major attractions of foreign exchange markets include: (1) high liquidity levels; (2) high accessibility for many different types of participants; and (3) efficiency. The U.S. dollar, the euro, the U.K. pound and the Japanese yen continue to be the four most important currencies in the world and account for the dominant share of foreign exchange trading. There is also a notion that currencies have become an asset class in themselves as investors search for yield around the globe.
UNIT 3EXCHANGE RATES AND THEIR MOVEMENTS
Learning objectives:
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After studying this unit, you should be able to:
INTRODUCTION/DEFINITION. FACTORS DETERMINING EXCHANGE RATES CURRENCY MOVEMENT FACTORS THE IMPACT OF REAL INTEREST RATES SPECULATION AND OTHER FACTORS
INTRODUCTION/DEFINITION
The world trade, export and import of commodities, cross-border movement of manpower and capital, travel and tourism and export of services, all necessitate the need for exchange of currency of one country to the currency of another country. Exports of goods manufactured in India, to USA, are paid in US dollars where the exporter needs to convert the USD proceeds of the bill into Indian rupees. Similarly, import of capital goods from Germany into India, billed in Euro, is to be paid in Euro, by converting Indian rupees into Euro. This is Foreign Exchange. For the Indian exporter or the importer the US dollars or Euro is foreign exchange, while for the American (buyer of Indian goods) or the German (seller of capital goods), Indian rupee is foreign exchange. Thus, in today’s world, when nations survive on inflow or outflow of goods, capital or services, foreign exchange has become an integral part of the world financial system. Can we think of not exporting our surplus produces or not importing the new technology, machineries consumables into India? Can we do without import of capital, when we lots of funds for growth related investments? Travel, tourism, exports, imports of goods and services, repatriation of savings by expatriates, all depend foreign exchange.
FOREIGN EXCHANGE - DEFINITION AND MARKETS From the above, it can be observed that the term foreign Exchange is used, more popularly to denote foreign currency, i.e. currency of another country, as well as the exchange of one currency into another. Foreign Exchange Management Act (FEMA), 1999, defines foreign exchange as:
a. “Foreign Exchange means foreign currency, and includes: All deposits, credits and balances payable in foreign currency, and any drafts, traveller’s cheques, letters of credit and bills of exchange, expressed or drawn in Indian currency and payable in any foreign currency,
b. 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 the other.”
Thus, broadly speaking, foreign exchange is all claims payable abroad, whether consisting of funds held in foreign currency with banks abroad or bills, checks payable abroad.
A foreign exchange transaction is a contract to exchange funds in one currency for funds in another currency at an agreed rate and arranged basis.
Exchange rates thus denote the price or the ratio or the value at which one currency is exchanged for another currency. The number of units of one currency which exchange for a given number of units of
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another currency is exchange rate of the currency. For example, 1 US dollar is equal to Rs 45.50, or 1 Euro is equal to 1.25 US dollar.
The exchange rate is a dynamic rate; which varies from day to day, minute to minute and at times per second also depending upon various factors. We shall learn more about the forex markets and other aspects as we go ahead.
FACTORS DETERMINING EXCHANGE RATES
The quotations in the Forex markets depend on the delivery type of the foreign currencies, i.e. exchange of streams of the two currencies being exchanges. The spot rates, being the base quotes in the forex markets, are more dynamic and are effected by varied reasons, a few of which are fundamental and other technical. The main factors, which influence movement of exchange rates, can be summarized as under:
a. Fundamental Reasons
These include all those causes or events, which effect the basic economic and fiscal policies of the concerned government. The causes normally affect the long term exchange rates, while in the short-run, many of these are found ineffective. In a long run, exchange rates of all currencies are linked to fundamentals, as given under:
Balance of payment— generally a surplus leads to a stronger currency, while a deficit weakens a currency.
Economic growth rate — a high growth leads to a rise in imports and a fall in the value of currency, and vice versa.
• Fiscal policy — an expansionary policy, e.g. lower taxes can lead to a higher economic growth.
• Monetary policy — the way, a central bank attempts to influence and control interest and money supply.
• Interest rates — high domestic interest rates tend to attract overseas capital, thus the currency appreciates in the short term. In the longer term, however high interest rates slow the economy down, thus weakening the currency.
• Political issues — political stability is likely to lead the economic stability, and hence a steady currency, while political instability would have the opposite effect.
b. Technical Reasons
Government controls can lead to an unrealistic value of a currency, resulting in violent exchange rates. Freedom or restriction on capital movement, can affect exchange rates, to a larger extent. This is a recent phenomenon, as seen in Indonesia, Korea, etc. Huge surpluses of petroleum exporting countries, due to sudden spurt in petroleum prices, which could not be utilized in these countries, needs to be invested in overseas centres, thus creating huge movement of capital to these countries and resultant
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appreciation of the relative currency. Capital tends to move from lower yielding to higher yielding currencies, and results, is movement in exchange rates
c. Speculation
Speculative forces can have a major effect on exchange rates. In an expectation, that a currency will be devalued, the speculator will short sell the currency for buying it back at a later date at a cheaper rate. This very act can lead to vast movements in the market, as the expectation for devaluation grows and extends to other market participants.
Speculative deals provide depth and liquidity to the market and at times act as a cushion also, if the views do not lead to a contagious effect.
CURRENCY MOVEMENT FACTORS
To date, there is no exchange rate model that can predict future currency prices with 100% accuracy. In rapidly growing global foreign exchange markets, currency movements become harder to predict as more participants enter the market on a daily basis, bringing with them all their research opinions, emotions, and expectations about where currencies should be headed. Currency movements in the short term can be influenced by publicly available information like the release of the country’s gross domestic product data, the consumer price index, or employment data. The following publicly available information can have immediate impact on currency movements:
• Local economic data releases and the anticipation of those releases.• Economic data releases in foreign countries, especially of major trading partners, and the
anticipation of those releases.• Central banks, such as the U.S. Federal Reserve or the European Central Bank, raising or
lowering interest rates.• Central banks making public their thoughts on monetary policy.• Expectation of central banks making public their views on local interest rates or monetary policy.• Political developments, both globally and in individual countries.• Natural disasters and perceptions about how they will impact economies.• Changes in commodity prices, particularly oil and gold.
This list is not exhaustive, but these factors would be among the more important catalysts for currency movements.
But there is also information that is not immediately publicly available, such as individual traders’ in-house strategic analyses on currencies or buy and sell orders that come from customers, which can affect the decision process of market participants. The activities of market participants such as central
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banks, commercial banks, hedge funds, individual investors, and multinational corporations will be influenced by a mixture of all these factors.
Central banks around the world such as the U.S. Federal Reserve, carry out actions called ”monetary policy” to influence the availability and cost of money and credit. The do this to achieve certain national economic goals such as lowering inflation or promoting growth. In 1913 the passage of the U.S. Federal Reserve Act gave the monetary policy power to the Federal Reserve. There are three tools of monetary policy that the Federal Reserve or “Fed” uses: (1) open market operations, (2) the discount rate and (3) reserve requirements. While the FED’s board of Governors makes decisions regarding the discount rate and reserve requirements, the Federal open market committee (FOMC) is responsible for so called open market operations. By using those tools the Fed is able to influence the balances that banks and other depository institutions hold at Federal Reserve banks and are thus able to alter the federal funds rate which is the interest rate which banks lend to each other overnight. A change in the federal funds rate influences a whole host of financial and economic events such as other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and such economic variables such as employment, production output, and prices of various goods and services. The 12 members on the FOMC; including various officials of the Federal Reserve System, hold eight annual meetings where they determine monetary policy after they have reviewed economic and financial conditions and any risks to price stability. The Federal Reserve’s commentary shown above illustrates how such variables as natural disasters, energy prices, political uncertainties and interest rate changes can influence currencies
Currency strategists will look at such factors to forecast price targets for currencies. For example, if a strategist was tasked to predict the expected performance of the Canadian dollar against the U.S. dollar through 2007, he would probably factor in the expected performance of the U.S. dollar over the previous period, as well as expectations of commodity prices that Canada exports such as oil, the direction of interest rates in Canada, and the corresponding rate environment in the U.S. The strategist is also likely to look at expectations of capital and trade flows associated with the Canadian economy, and how Canada’s political landscape is likely to evolve over the period. Thus, in forecasting the expected performance of the “loonie,” the strategist essentially conducts a fundamental analysis of a country underlying economic conditions. To get a feel for these fundamental analyses, here are some common scenarios that can have an impact on currencies:
• If a country’s stock market rallies, its currency could strengthen. A stock market rally provides an ideal investment opportunity for individuals regardless of geographic location. As a result, there is a positive correlation between a country’s equity market and its currency. If the stock market is rising, funds will rush in to seize the opportunity. Alternatively, falling stock markets will see investors selling their shares to seek opportunities elsewhere. The correlation between stocks and currencies is strong enough to make currency trader’s watch stock market for cues on performance of currencies.
• If oil prices surge to record highs, it can have a negative impact on some currencies. A country’s dependence on oil is very important in determining how its currency will be hit by a spike in oil prices. There will be a greater negative impact on countries that are net oil importers. For example the U S is among the world’s largest net oil importers and thus its economy will be
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more sensitive to changes in oil prices than many other countries. Countries with alternative fuel sources, and other resources, have the ability to switch from strict oil dependence to other energy sources, which helps to reduce their exposure and sensitivity.
• An increase in a country’s unemployment numbers can have a negative impact on its currency. Currency prices reflect the balance of supply and demand for those currencies. A primary factor affecting supply and demand is the overall strength of the economy. The unemployment rate is a strong indicator of a country’s economic strength and therefore a contributor to the underlying shifts in supply and demand for that currency. When unemployment is high, the economy may be weak—and its currency may fall in value.
• If a country’s central bank makes a surprise decision to raise rates by more than expected, its currency could rally. Currency traders look at data related to interest rates very closely as interest rate differential are strong indicators of relative currency movements. If a country raises its interest rates, its currency can strengthen in relation to those of other countries because high interest rates help nations attract foreign investment. Economic indicators that have the biggest impact on interest rates are the producer price index, consumer price index, and GDP. Generally, the timing of an interest rate decision is known in advance. They take place after regularly scheduled meetings by the Federal Reserve, ECB, BOJ, and other central banks.
THE IMPACT OF REAL INTEREST RATES
Traditional macroeconomic exchange rate models are based on fundamental analyses. In these models, the basic force that drives exchange rates comes from the balance between supply and demand for example if the demand for the U.S. dollar exceeds its supply at the current exchange rate against the euro the price of US dollar in terms of the euro will rise. Conversely, if supply exceeds demand, the price will fall. Demand and supply factors that govern exchange rates become much more complex than that because people don’t use currencies just to purchase foreign goods and services, but also for activities like cross-border investment and speculation. This opens up many other variables that must be considered when addressing exchange rate movements, as underscored in the Federal Reserve Bank of New York’s commentary cited previously. One of the most important factors, for example, is how investors ride interest rate differentials between countries.
We know that interest is the price paid to entice people with funds to save rather than spend, or to invest in long-term assets rather than hold cash. Therefore, interest rates reflect the interaction between the supply of savings and the demand for capital, or between the demand for money and its supply. A key determinant of these interest rates is inflationary expectations. Global investors broadly desire a real return from their investments, and changes in forecasts over future inflation are consequently reflected in current exchange rates. “Real return” here refers to the interest rate minus the inflation rate.
Here is an example of how this works: If Australia’s interest rates are higher than Japan’s then Japanese investors will for example, want to buy Australian bonds to take advantage of the higher rates and corresponding returns. But to do so they must first sell Japanese yen and buy Australian dollar at the current exchange rate between the two currencies. Next, Japanese investors are not likely to park their
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money in Australian bonds indefinitely and, at some point in the future, will want to bring their proceeds home and convert them back to yen. So they will also be interested in having an idea of what the exchange rate between the yen and the Australian dollar will be in the future. The expected return for these investors will have to factor in both the interest rate and the expected movement in exchange rate between the two currencies. That is, the demand for yen will depend not only on, the current exchange rate, but also on anticipation of future exchange rate movements against the Australian dollar. The Japanese investors’ exchange rate predictions will, in turn, be influenced by their estimate of what the inflation rates will be in each country. If inflation in Australia rises above the prevailing interest rates, the Japanese investors will then expect a weakening of the Australian dollar. If Japanese inflation is lower than the prevailing interest rates then the Japanese yen will become more attractive.
SPECULATION AND OTHER FACTORS
The demand for foreign exchange to support international trade is not as complex as interest rate differential considerations since term trade patterns are reasonably predictable—for example, the market will know roughly at which levels domestic importers will buy foreign currencies with their local currency to pay for the goods they buy overseas, and they will also know where exporters will sell foreign currencies which they receive for goods sold in their export markets. Speculative demand, on the other hand, causes most of the short-term fluctuations in currency markets. Speculators have to guess constantly where currencies are headed, and their guesses are often revised when their short-term targets are reached or if currency movements run contrary to their initial guesses. As foreign exchange speculators change their views about the future, their demand for currency changes, resulting in exchange rate fluctuations.
In addition to all these drivers, central banks also intervene in foreign exchange markets for reasons that can be quite different from the other participants. For instance, the Bank of Korea could easily decide to sell Won in foreign exchange markets. The bank’s intention could be to keep the value of the won low so that the country’s exports are more competitive. The greater demand for South Korea’s exports will feed back positively into its economy.
The scenarios just described generate supply and demand drivers for currencies across the globe. The accompanying foreign exchange transactions come on the back of thousands upon thousands of decisions, made each day, to buy or sell currencies. To determine exchange rates, we would have to consider the influence of these decisions on currencies, which is by no means an easy task. Different empirical exchange rate models incorporate one or more of these variables—all of which can have an impact on exchange rates.
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UNIT 4EXCHANGE RATE MECHANISM
Learning objectives:
After studying this unit, you should be able to:
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Types and Calculation READY OR CASH, TOM, SPOT, VALUE DATE SPOT AND FORWARD RATES DIRECT AND INDIRECT QUOTES CROSS RATES & CHAIN RULE FIXED VS. FLOATING RATES ARBITRAGE IN EXCHANGE
Types and Calculation
Due to vastness of the market, operating in different time zones, most of the Forex deals are done on SPOT basis, meaning thereby that the delivery of the funds takes place of the second working day following the date of deal! Contract. The rate at which such deals are done is known as SPOT rates. Spot rates are the base rates for other FX rates. The date of delivery of funds on the date on which the exchange of currencies actually takes place, is also referred to as ‘value date’. The delivery of FX deals can be settled in one or more of the following ways:
Ready or Cash
Settlement of funds on the same day (date of deal), e.g. if the date of Ready/Cash deal is 25 October 2009 (Monday), settlement date will also be 25 October 2009.
TOM
Settlement of funds takes place on the next working day of the date of deal, e.g. if the date of TOM deal 25 October 2009 (Monday), settlement date would be 26 October 2009 (provided it is a working day for the markets dealing as I as where currency is to be settled.).
SPOT
Settlement of funds takes place on the second working day after/following the date of contract/deal, e.g. if the date of Spot deal is 25 October 2009 (Monday), settlement date will be 27 October 2009. (Presuming all markets are working on 25, 26 and 27 October 2004.).
Value Date
This is the term used to define the date on which a payment of funds or entry to an account becomes actually effective and/or subjected to interest. In the case of payments on Telegraphic Transfers (TT) the value date is usually the same in both centers, i.e. payment of the respective currency in each centre takes place on the same day, so that no gain or loss of interest accrues to either party. Such payments are said to be valuer compensee, or, simply, here and there. If there is time lag between receipt of funds at one centre and payment of funds at another centre, compensation should be paid to party, which is out of funds. Normal mode of compensation is interest, which should be recovered/paid separately. This may be done by adjusting the value date if acceptable to both the parties. Thus, the date of settlement of funds is known as value date.
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Forward
Delivery of funds takes place on any day after Spot date, e.g. if the date of forward deal is 25 October 2009 (Monday), for value settlement date 25 November 2009, it is a forward deal.
Spot and Forward Rates
As explained earlier, in the Forex market all rates are quoted are generally ‘Spot Rates’. The spot rates are for delivery of currency or exchange of the streams of currencies dealt in, on the second day from the date of deal/transaction. Say USD/INR quoted as 1 USD = 45.50 INR, or GBP/USD quoted as 1GBP=1.80USD
When the delivery of the currencies is to take place at a date beyond the Spot date, then it is a forward transaction, and the rate applied is called forward rate.
Forward Margins—Premium and Discounts
Forward rates are derived from spot rates, and are function of the spot rates and forward premium or discount of the currency, being quoted.
Forward rate = Spot rate + Premium - Discount.
If the forward value of the currency is higher than (costlier) the spot (present) value, then the currency is said to be at a Premium, say, if the spot GBP against USD is being quoted at 1.8350, and 1 month forward as 1.8450, then GBP is dearer, value one month forward, and a premium of 100 pips is being charged for the same.
Similarly, if the forward value of a currency is cheaper than the present value (spot), the currency is said to be at a Discount. In the above example, where the spot GBP is quoted as 1.8350, against USD, and 1 month forward as 1.8450 (10O pips), while the GBP is at a premium, the USD, the other currency is at a discount against the GBP
Let us take another example. Indian rupee spot being quoted as 45.50/52, against USD i.e. one USD is being bought at 45.50 and sold at Rs 45.52. Now if the six-month premium being quoted is 40/42 paise, it means that the USD is being quoted dearer in forward, and is being quoted as 45.90/94. Here the USD is at a premium, while the INR at a discount.
Thus, a correlation is clearly established as the quotes are for a pair of currencies, where one is exchanged for another, (GBP/USD, USD/INR, USD /SGD, Euro/USD, USD/JPY, etc.).
The forward premium and discount are based on the interest rate differentials of the two currencies involved, as also on the demand and supply of forwards in the market. The demand and supply depends upon various factors, e.g. movement of capital in normal times (flight of capital), trade and balance of payment and their financing, labour problems, political speculative activities, etc.
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The interest factor is the basic factor in arriving at the forward rate. If the rate of interest, say in US, for three months prime bank bills is 2% p.a. while similar paper in London can be purchased at a rate of interest of 4% p.a. there will be a flow of funds from USA to London to take advantage of higher yield shown by UK bills. (Assuming there are no exchange controls and free movement of capital is allowed.) The US investor will have to buy GBP by surrendering his USD (owned or borrowed) in the spot market and the, GBP so obtained by him would be invested in the UK bills. This will lead to a demand for GBP in the spot market. At the maturity of pound bills, the pounds received would be reconverted back to US dollars. This will lead to a demand for US dollars in the forward.
This gain or sacrifice will be adjusted in the forward rate of currencies (as forward margin — premium or discount), dealt in the foreign exchange market, to ensure a no-profit no-loss situation.
Therefore, the forward price of a currency against another can be worked out with the following factors:
(i) Spot price of the currencies involved.
(ii) The interest rate differentials for the currencies.
(iii) The term, i.e. the future period for which the price is worked out.
It would be relevant to emphasize here that the forward rate so worked out is no indicator of the future trend of the currency values.
Direct and Indirect Quotes
As given elsewhere, the price of the currency can be expressed either as one unit of home currency, equal to so many units of foreign currency, or as one unit of foreign currency equal to so many units of home currency.
Under direct quotes, the local currency is variable, say as in India, 1 USD = Rs 45.50. The rates are called direct, as the rupee cost of foreign currency is known directly. These quotes are also called Home currency or Price Quotations.
On the other hand under indirect method, the local currency remains fixed, while the number of units of foreign currency varies. For example, Rs 100.00 = 2.10 USD.
It would be worthwhile to mention that globally a practice is being followed Where all currencies, (except a few) are quoted as direct quotes, in terms of USD (1 USD = so many units of another currency). Only in case of GBP (Great Britain Pound/British Pound), Euro, AUD Australian Dollars), and NZD (New Zealand Dollars), the currencies are quoted as indirect rates, i.e. one GBP, Euro, AUD, or NZD = so many units of USD.
Cross Rates
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When, we deal in a market where rates for a particular currency pair are not directly available, the price for the said currency pair is then obtained indirectly, with the help of cross rate mechanism. This can be explained with the following example:
Suppose, we intend to get a quote for Euro/rupee and no one is prepared to quote Euro/Rs directly in the market. We can work out a Euro/Rs quote through Euro/USD and USD/Rs quotes.
Euro/USD quote would be available in the international markets and USD/RS would be available in the domestic market. By crossing out USD in both the quotes, we can arrive at an effective Euro/Rs quote.
This is the basis for working out cross rates. Cross rate mechanism is possible solution for calculation of rates for currency pairs which are not actively traded in the market.
For example, we need to quote GBP against INR, but in India, usually GBP is not quoted directly, as such we need to take rates for USD/INR and GBP/ USD to compute GBP/INR rate.
if. USD/INR is 45.50/60, and GBP/USD is 1 .8340/50, then, to GBP/INR rate, we need to cross both the given rates, which would give us GBP/INR rate as
83.2636/83.4925.
Chain Rule
It is used in attaining a comparison or ratio between two quantities which are linked together through another or other quantities and consists of a series equations, commencing with a statement of the problem in the form of a query and continuing the equation in the form of a chain so that each equation must start in terms of the same quantity as that which concluded the previous equation.
Fixed vs. Floating Rates
The fixed exchange rate is official rate set by the monetary authorities for one or more currencies. It is usually pegged to one or more currencies. While under floating exchange rate, the value of the currency is decided by supply demand factors. In some cases, even fixed exchange rates are allowed to fluctuate between definite upper and lower bands, as fixed by the monetary authority of the country.
Bid and Offered Rates
The buying rates and selling rates are also referred to as bid and offered rates. In a USD/INR quote, of 45.00/02, the quoting bank is bidding for USD at 45.00 and is offering to sell the USD at 45.02. On the other hand, in a GBP/USD rate 1.8810/15, the quoting bank is willing to buy GBP at 1.8810 willing to sell at 1.8815.
Exchange Arithmetic — Theoretical Overview
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All foreign exchange calculations have to be worked out with extreme care and accuracy and also the use of decimal point has to be correctly placed. Constant check is also required to minimize the risk of mistake, as the markets work on very thin margins. An error in one quote may erode earnings from several trades/transactions.
Per Cent and Per Mille
A percentage (%) is a proportion per hundred, e.g. 1% is one part in every hundred parts such as Rupee 1 per Rupees 100, while per mille means thousand, e.g. 1 per mille is one part in every thousand, such as Rupee 1 per Rupees 1,000.
Percentage or per mille can also be used to advantage in checking roughly any calculations, such as interest when allowed in a rate of exchange
Arbitrage in Exchange
Arbitrages consist in the simultaneous buying and selling of a commodity in two more markets to take advantage of temporary discrepancies in prices. As applied to dealings in foreign exchange, arbitrage consists of the purchase of one currency for another in one centre, accompanied by an almost immediate resale against the same currency in another centre, or in operations conducted through three or more centres and involving several currencies. A transaction conducted between two centres only is known as simple or direct arbitrage. Where additional centres are involved, the operation is known as compound or three (or more) point arbitrage. Such operations must be carried must be carried out with the minimum of time delay if advantage is to be taken of temporary price differences, and they require a high degree of technical skill. Speed in handling the deals would be the foremost aspect in such deals, as markets usually tend to move towards such deals and the differences get wiped out in no time.
Rates quoted to merchants, or for retail transactions are specified by the nature of transactions. By this, the different rates could be applied for TT Bills transactions, Foreign Money or Cash transactions, Travellers Checks transactions, or even personal checks buying. The rates would be different for buying or selling transaction, levying different margins over the interbank rates, depending upon the nature of transaction.
Key learning:
o Authorized Dealers: banks / institutions authorized to deal in foreign exchange
o Value Date: The date of settlement of funds
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o Cross Rate: Price of a currency pair not directly quoted arrived from price of two other currency pairs.
o Forward Contract: It is a binding contract for purchase / sale at a future date.
o Premium: A currency is said to be at a premium if it commands more units of another currency at a future date.
o Discount: A currency is said to be at a discount if it commands less units of another currency at future date.
o Premium / Discount: It represents interest rate differential in a forward contract
o Swap: It is an exchange of specific streams of payments over an agreed period of time.
o Fixed Exchange Rate: Official exchange rate fixed by the monetary authority
o Floating Exchange Rate: Market exchange rate decided by supply and demand factors
o Direct Exchange Rate: Exchange rate expressed in terms of home currency quotations.
o Indirect Exchange Rate: The exchange rate expressed in terms of foreign currency quotations.
o Ready / Cash Rate: Value to be settled the same day – value today
o TOM Rate: Value to be settled tomorrow, next day.
o SPOT Rate: Value to be settled on the second working day from the date of transactions
o Forward Rate: Value to be settled beyond SPOT value
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UNIT 5FOREIGN EXCHANGE DEALING ROOM OPERATIONS
Learning objectives:
After studying this unit, you should be able to:
QUALITIES OF A DEALER
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FUNDS POSITION, CURRENCY POSITION FRONT OFFICE, BACK OFFICE & MID OFFICE MANAGEMENT AND CONTROL OF DEALING ROOM RISK ASSOCAITED WITH FX DEALING ROOM
The Forex dealing room operations comprise functions of a service brand to meet the requirements of customers of other branches/divisions to buy or sell foreign currency fund Nostro accounts as also undertake proprietary trading in currencies. It acts as a separate profit center for the bank/institution.
The Dealers, who are actually involved in the buying and selling of currencies or doing market activities, are the most critical manpower, as their understanding of the job risk taking capacity and speed in decision making, all lead to lots of profits for the dealing operations. On the other hand a small mistake a misjudgment, may wipe off all days profit in a second. A good dealer needs a good understanding of the changing nature of things and cannot afford to be obstinate. Certain psychological qualities are prerequisites. The ability to work under stress, willingness to accept responsibilities, the ability to make decisions quickly a good measure of aggressiveness and above all willingness to recognize that one can be wrong. There must exist an atmosphere of complete trust within a dealing room.
A dealer has to maintain two positions —funds position and currency position. The funds position reflects the inflows and outflows of funds that is receivables and payables. Any mismatches in the receivables and payables will throw open interest rate risks, in the form of a possible overdraft interest in Nostro accounts, loss of interest income on credit balances. It is of utmost importance for a dealer to properly maintain the funds position.
The currency position on the other hand, deals with the overbought or oversold positions, arrived after taking various merchant or interbank transactions and the dealer will be concerned with the overall net position. This exposes the dealer to exchange risks from market movements. The dealer has to operate within the permitted limits prescribed for the exchange position by the management.
The other part of the dealing room is Back Office, which takes care of processing of deals, accounts, reconciliation, etc. This function is of the equal importance, any laxity in this area would also land the institution into unforeseen trouble. Either, it may negate the efforts of the dealers to generate profits, or it could be so lax that the dealers indulge in misreporting, or wrong doing, without the notice of the back office. It has both a supportive as well as a checking role over the dealers.
The third part is Mid Office, which deals with the risk management, and parameterization of risks for forex dealing operations. It acts as a check over the risk taken by the dealers as also supplements them by giving market information.
With the increase in volume of foreign exchange transactions arising out of expanding international trade, both in goods and services, cross border flow of money, and also because of the authorized
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dealers undertaking foreign exchange trading, the necessity for exercising management control over profit and loss evaluation and adhering to the prescribed guidelines/limits, needs no emphasis.
Reserve Bank of India has approved Foreign Exchange Dealer association India guidelines on Uniform Standard Accounting Procedure for valuation of foreign exchange profits and losses by authorized dealers, which should be undertaken at least on a quarterly basis. However, the mechanization of dealing operations, facilitate profit evaluation of lesser frequencies as well, and in some organizations on daily basis.
As per extant guidelines, each foreign currency position covering all component of foreign currency (exchange) position, viz., mirror accounts of the currency, foreign currency notes held, import suspense account, all spot and forward positions, including export bills (both sight and usance), transactions which are reported to the position desk but not adjusted in the accounts, i.e. actual vouchers not put through, overdue contracts — inter-bank, if any and merchant contracts, should be revalued separately.
Foreign exchange dealers association of India advices the valuation rates based on ongoing market rates on month end dates to enable the authorized dealers to revalue their foreign currency positions.
Management and Control of a Dealing Room
Reserve Bank of India, have advised that the Board of Directors should frame an appropriate policy and fix suitable limits for its Forex functions.
The management of dealing room operations should focus on risk associated with foreign exchange dealing room operations, which arise due to complex nature of foreign exchange markets and the volatile nature of exchange movements.
The major risks associated with foreign exchange dealing operations, where the management needs to frame policies and keep a constant vigil, can be summarized as under:
Operational risk: It is a risk arising on account of human errors, technical faults, infrastructure breakdown, faulty systems or procedures or lack of internal controls.
Exchange risk: It is the most common and obvious risk in foreign exchange dealing operations and arise mainly on account of fluctuations exchange rates and/or when mismatches occur in assets/liabilities and receivables/payables.
Credit risk: It is a risk of loss which arises due to inability or unwillingness of the counter party to meet the obligations at maturity the underlying transactions
Credit risk: is further classified into pre-settlement risk and settlement risk. Pre-settlement risk is the risk of failure of the counter party before maturity the contract thereby exposing the other party to cover the transaction at the ongoing market rates.
Settlement risk: is the risk of failure of the counter party during the course of settlement, due to the time zone differences, between the two currencies to be exchanged. That is, where one party performs its
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part of the contract by delivering the currency to be delivered by it but the counter party fails before delivering the currency to be delivered by it, in a different time zone.
Liquidity risk: Liquidity risk is the potential for liabilities to drain from the bank at a faster rate than assets. The mismatches in the maturity patterns of asset and liabilities give rise to liquidity risk. Thus it is a risk which may arise due a party to foreign exchange transaction unable to meet its funding requirements or execute a transaction at a reasonable price.
Gap risk/Interest rate risk: In the course of its business, a bank buys and sells currencies for spot and forward value. It may not be always possible for the bank to match its forward purchase and sales. Thus, if the purchase and sale take place for different value, while the bank may completely stand hedged on exchange front, it creates a mismatch between its assets and liabilities referred to as GAP.
These gaps are to be filled by the bank by paying/receiving appropriate forward differentials. These forward differentials are in turn a function of interest rates and any adverse movement in interest rates would result in adverse movement of forward differentials thus affecting the cash flows on the underlying open gaps or mismatches.
Therefore, it is the risk arising out of adverse movements in implied interest rates or actual interest rate differentials.
Market risk: It is a risk which arises due to a party to a foreign exchange transaction unable to exit or offset a position quickly at a reasonable price.
Legal risk: It is the risk arising on account of non-enforceability of contract against counter party.
Systemic risk: This risk is the possibility of a major bank failing and the resultant losses to counter parties reverberating into a banking crisis.
Country risk: It is the risk of counter party situated in a different country unable to perform its part of the contractual obligations despite its willingness to do so due to local government regulations or political or economic instability in that country.
Sovereign risk: It is a sub-risk in the overall country risk in that certain state owned entities themselves quoting their sovereign status claim immunity from any recovery proceedings of fulfillment of any obligations they had originally agreed to, as in these countries, the sovereign status cannot be questioned even in a court of law.
A comprehensive and accurate management control of dealing room operations would cover assessment of the above risk exposures and their management. It is to be noted that foreign exchange dealing room operations are considered to be profit centres in most of the major banks and a complete risk aversion will only help the management to avoid loss. To generate profit it is essential to have a proper risk appetite to optimize profit, through proper risk - reward trade off.
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More about these risks and their management and control would be covered under the unit on Risk Management.
Foreign exchange dealing operation is a highly specialized function and has to be performed by weII-trained personnel. Typically a dealing room should consist of dealing and back office staff, who are responsible for the follow up of deals put through by the dealers. The need for effective control over dealing room operations is of great importance as possibilities exist for manipulation of exchange rates, dealing positions, washing names, mismatches, etc. A supreme principle of operational procedures and the area of dealing room activities is a clear functional separation of dealing, back office accounting (processing and control) and reconciliation.
The above details on the dealing room and its operations make it clear that the operations are crucial and important to any bank or institution. The contribution of exchange profit (from merchant transaction as well as trading operations) has its own place in the bottom line of the bank, as such Iarge players in major markets, have deployed a large number of dealers and other staff, supported by sophisticated communication and IT systems with huge investments, to handle the forex dealing operations.
These large dealing rooms have separate desks for traders, as also for derivatives, each of which specializes in its own product, and are constantly in the market to make money for the bank.
In India also, a number of banks have large dealing rooms, and have grown to cater to various products, as permitted by Reserve Bank of India.
Key learning
o Funds Position: Reflects the inflows and outflows of funds, which are receivables and payables.
o Currency Position: Deals with the over bought or over sold positions arrived after taking various merchant or inter bank transactions.
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o Dealers Pad: The pad maintained by the dealer to record the days transactions
o Net Position:
o Front Office: Dealers put through transaction buy / sale transactions
o Mid Office: Deal with the risk management and parameterization of risks of forex dealing operations
o Back Office: Takes care of processing of deals, account, reconciliations
o FEDAI: Foreign exchange dealers association of India
o Value At Risk:
o Stop Loss Limit: maximum movement of rates against the position held so as to trigger the limit – or say maximum loss limit for adverse movement of rates
o Cover Operation:
o Day Light Limit: Maximum amount the bank can expose itself at any time during the day, to meet customers needs or for trading operations
o Gap Limit: Maximum inter period / month exposer which a bank can keep are called gap limit. In foreign exchange transaction, the gap refers to the period between the maturities for purchase and the maturities for sales of each foreign currency.
o Counter Party Limit: Maximum amount that a bank can expose itself to a particular counter party.
o Dealer Limit: Maximum amount a dealer can keep exposer during the operating hours.
o Deal Size Limit: Highest amount of deal size a deal can be made, to restrict operational risk on large deals.
o Mirror Accounts:
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o Overnight Limit: Maximum amount a bank can keep overnight, when the markets in its time zone are closed.
UNIT 6RISK IN FOREIGN EXCHANGE OPERATIONS
Learning objectives:
After studying this unit, you should be able to:
INTRODUCTION
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DEFINITIONS OF RISK AND RISKS IN INTERNATIONAL TRADE RISKS IN FOREIGN EXCHANGE OPERATIONS WHAT IS RISK AND VARIOUS RISKS IN INTERNATIONAL TRADE MANAGEMENT OF THESE RISKS AND VARIOUS GUIDELINES RELATED TO RISK
MANAGEMENT
INTRODUCTION
Any activity you indulge in is associated with risk — and may result in some loss or some gain. It is an unplanned event with financial consequences resulting in loss or reduced earnings. The risk could be more or less depending upon the area of operation, volume, number of players, etc. The arena of international trade and foreign exchange operations is also prone to risks, mainly due to complex nature of transactions, the individual characteristics of different currencies as also a vast area of operations. Like in any other human activity, risk cannot be avoided in international trade and foreign exchange operations. While in the international trade buyer risk, seller risk, shipping risk etc., keep the parties on vigil, the foreign exchange operations are plagued with exchange risk, settlement risk, liquidity risk, country risk, sovereign risk, interest rate risk, and operational risk. Any type of risks needs to be accepted and managed effectively and efficiently to minimize the adverse effect an maximize the profit/goals of the organization.
The risks related to volatility in prices, exchange and interest rates of exposures such as commodities, currencies or shares and bonds, need innovative instruments that could hedge their value.
Derivatives are such instruments which when added to the exposure will neutralize or alter to acceptable levels, the uncertainty profile of the exposure. The values of these financial instruments are derived from the values of the underlying exposures.
Some of the popular derivative instruments in foreign exchange market are forward contracts, options, swaps, forward rate agreements and futures.
One of the avowed virtues of derivative instruments is that they enhance the system of information transmission by offering greater liquidity with lower transaction costs. They are also supposed to service a productive economic function by providing a mechanism by which risk transfers are facilitated between players who are less willing to bear risk to those who are more willing to do so.
Very importantly, derivative instruments offer a vehicle to manage risk. Man has always struggled to manage risk. Risk arises because man is unable to visualize the potential state on some future date. He tries to manage risk by seeking to ensure the existence of suitable state of affairs on the future date and to that extent, minimize the possible detrimental effects of an adverse situation at that point of time.
Now, let us go in detail and study the risks in the international trade and the hedging tools, namely, derivative instruments.
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DEFINITIONS OF RISK AND RISKS IN INTERNATIONAL TRADE
A risk can be defined as an, unplanned event with financial consequences resulting in loss or reduced earnings. An activity which may give profits or result in loss may be called a risky proposition, due to the uncertainty or unpredictability of the activity or trade in future. While, in human life, the risk is related to illness, impairedness or loss of life, in commercial and business activities, the business profit or loss would depend upon how the business is run or its affairs managed.
In other words it can be defined as the uncertainty of the outcome. A risk in any currency, commodity or an object due to exposure in that particular currency, commodity or the object. Like currency risk, commodity price risk, interest rate risk, etc.
International trade is surrounded by a number of risks, more than that affect domestic trade. This is because of its vast arena of operations, where the buyer and the seller are located in different countries, the goods and the value of goods move in opposite directions, the currency of the country of the buyer and the currency of the country of the seller have their own values which undergo change frequently, while the invoicing may be in a third currency, acceptable to both.
Thus, the international trade has to face following risks:
A. Buyer Risk
Once the buyer orders for the goods, and the sellers prepares to procure, manufacture, and ship the goods, there looms a large shadow of non acceptability, non-payment, quality acceptance, credit risk, and the seller is exposed to these risks until payment is received by him. The seller is plagued with these uncertainties, which loom large until the transaction is complete with the buyer accepting the goods, to his satisfaction and the seller getting payment for his job.
B. Seller Risk
Seller may not ship the goods after receiving advance payment, may ship poor quality goods and may also ship the goods after considerable delay, which may either lead to cancellation or delays in further orders taken by buyer or even penalties in delays/non-shipment. The buyer is plagued with these uncertainties.
Over the period, when the buyer/seller undertakes a few transactions, know each other’s business well, the buyers and sellers risk reduces to a great extent.
C. Shipping Risk
Even, after both the buyer’s and seller’s willingness to fulfill their commitment responsibilities and obligations, the other intermediaries to international trade like shipping companies, handling agents, port authorities, local transporters or even loaders, etc., may cause/create risks which may lead to delays, even non-shipment of goods in time, leaving both the parties helpless. Some of these risks could be due to:
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— Goods mishandled
— Goods abandoned
— Goods siphoned
— Goods wrongly delivered
— Goods delivered at another destination
— Goods appropriated for freight payment
— Transshipment risk
— Strike by local transporters causing delay in reaching goods to ports
— Strike by porters effecting loading of goods into the ship
— Backlog/un-availability of containers due to delayed train movements
— Attack by sea pirates causing delays, breakages, loss of goods, etc.
Due to above risks, beyond the control of buyers and sellers, nations at times declare shipping, and other related activities as essential services to promote cross border trade, particularly when the country largely depended either on exports or imports.
D. Other Risks
In addition to the above, international trade can face risk from several factors which could crop up from nowhere, without any inkling and control by buyer or seller.
— bank failure risk
— Settlement risk
— Competition
— Genuineness of documents
— price risk
— Legal risk
— spread risk
— market risk (absorption/rejection)
RISKS IN FOREIGN EXCHANGE OPERATIONS
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As explained earlier, forex operations and markets are somewhat different from other commodity markets and peculiar in nature, due to the reasons that they are largely over the counter market, open 24 hour-a-day, without any single location and barriers, fluctuations registered almost every four seconds, effect of other markets, effected by controls/policies of respective governments, delayed settlements due to time differences, etc. These peculiarities expose the participants to various risks. The participants, as such have to exercise extreme caution in managing forex operations. Any laxity on his part may result in losses and exposures, ruining the whole business. Some of the very common risks faced in foreign exchange operations are: exchange risk, settlement risk, liquidity risk, country risk, sovereign risk, interest rate risk, operational risk, etc.
Let us check on these risks individually which have been discussed below:
A. Exchange Risk
Movements in exchange rates can adversely affect the value of our foreign exchange holdings, i.e. receivables and payables (purchases and sales), if not covered at the appropriate time, with due watch on the market moves. Normally, the dealer is expected to cover the transactions immediately (by entering into matching and opposite transactions), without loss of time. In case this is not done, then he is exposed to exchange risk. This is the most common and obvious risk in foreign exchange dealing operations. The markets may move against him, resulting in loss. Thus the dealer has to immediately cover his positions and keep constant watch on his positions and the market moves, so as to not to get effected by adverse movements.
A position in a given currency arises when assets and outstanding contracts to purchase that currency exceed the liabilities plus the outstanding contracts to selI that currency. In the former case, the bank will have a long (overbought) position and would be exposed to a risk if the currency depreciates in value. In the latter case, the bank will have a short (oversold) position and would stand to lose if the currency appreciates in value. This overbought or oversold position is the open position for the dealer.
In the present world, when globe is literally wired, major currencies of the world viciously floating against each other, the risk of open position assumes considerable significance.
As due to market lot requirements thin trading on select days, or other events, it may not be possible to cover each and every transaction individually, this risk has to be controlled and managed by prescribing suitable limits (daylight and overnight limit, single deal limit — trading position limit, volume limit, overall overnight open position limit, stop loss limit, gap — forward mismatch limit, etc.). In fact, it is a practice to accumulate and keep positions open, taking a view on the movement of exchange rates, like possible depreciation/appreciation of currencies, etc., but all within the prescribed limits.
Reserve Bank of India has authorized the boards of respective banks to specify and approve limits relating to forex operations. Banks, according to their merchant turnover requirements, trading skills and volumes, as also considering the capital base, fix various limits for their forex dealing operation.
B. Settlement Risk (Pre-settlement and Settlement Risks)
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The international financial system evolves around foreign exchange markets Forex markets facilitate conversion of currencies, movement of funds, global investments, travel and tourism, all culminating into a huge daily turnover, of over US$ 1.9 trillion. This volume is transacted between the market participants worldwide without the use of one single central clearing house — it is truly over the counter market.
In the absence, of such a single, global, centralized clearing house, each foreign exchange market participant has to make and receive payments on an individual basis. This entails counter-party credit risk for each transaction. Any disruption in the market due to sudden doubts about the solvency of one of the market participants could have serious repercussions for the global trade and finance and for the international banking system as a whole.
Thus credit risk in foreign exchange operations, is the risk of failure of counter party, whether a bank or a customer, to meet obligation at maturity of the contract, which could result in the need for resultant open position to be covered at an ongoing rate. This could happen prior to settlement by one of the parties or subsequent to execution by one party but before execution by the other one. The risk is, thus, classified into pre-settlement risk and settlement risk.
Pre-settlement risk is the risk of failure of the counter party, due to bankruptcy closure or any other reason, before maturity of the contract thereby compelling the bank to cover the contract at the ongoing market rates. This entails the risk of only market differences and is not an absolute loss for the bank. Settlement risk is the risk of failure of the counter party during the course of settlement due to the time zone differences between two currencies to exchanged. That is where the bank in earlier time zone say Japan or Australia performs its part of the contract by delivering the currency to be delivered by it but the counter party, in another time zone, say Germany, fails before delivering the currency to be delivered by them, which may still be in a third time zone, say USA. Such an event means complete risk and loss for the bank which is in the earlier time zone.
In other words, at its core, settlement of a foreign exchange trade requires the payment of on currency and the receipt of another. In the absence of a settlement arrangement that ensures that the final transfer of one currency will occur if and only the final transfer of the other currency also occurs, one party to a foreign exchange transaction could pay out the currency it sold but not received the currency it bought. This principal risk in the settlement of foreign exchange transaction is variously called foreign exchange settlement risk or temporal risk or Herstatt risk (named after the 1974 failure of the Bankhaus Herstatt in Germany). This can happen because banks operate in different time zones.
As the nature of trade and forex business does not make it possible to totally eliminate the settlement risk, more particularly due to countries situated and operating in different time zones, the risk is recognized by the market participants by applying credit lines (limits) to each counter party to reduce the risk. The credit limits take the form of maximum outstanding limit as well as daily delivery limits for each bank.
The settlement risk could be avoided, if only settlement systems, operating on a single time basis, as also on a real-time gross settlement basis, are put in place. This would eliminate the time zone problems and
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also would pay only on ‘if received’ basis. The time zone differences could be eliminated, if the global books are linked to a single time zone, say GMT closing.
C. Liquidity Risk
When a party to a foreign exchange transaction is unable to meet its funding requirement or execute a transaction at a reasonable price, it creates Liquidity risk. It is also the risk of the party not being able to exit or offset positions quickly at a reasonable price. Here, for whatever reason, the market turns illiquid and positions cannot be covered or liquidated, except for high price.
For- example, in a deal of US dollar purchase against rupee, if the party selling US dollar is short of funds in the Nostro account then it may not be possible for him generate/borrow or buy USD to fund the USD account, then liquidity risk is said to have arisen. For this, proper funds and cash management practices have to be followed by the dealers.
Therefore liquidity risk is, the potential for liabilities to drain from the bank at faster rate than assets. The mismatches in the maturity patterns of assets and liabilities give rise to the liquidity risk. Liquidity risk could also arise, in case the markets turn illiquid leading to higher bid offer spread or even market makers getting out of the market. For protecting against the liquidity risk, the bank has to resort to control the mismatches between maturities of assets and liabilities. This is done by fixing limits for maturity mismatches and reduces open positions.
D. Country Risk
Country risk arises when a foreign entity or a counter party, private or sovereign, may be unwilling or unable to fulfill its obligations for reasons, other than the usual reasons or risks which arise in relation to all lending and investment.
Dealing in foreign currencies and with counter parties in another country will sometimes result in country risk. Movements of fund across international borders create uncertainty with regard to their receipts and payments and this uncertainty is defined as country risk. The foreign parties may be unwilling or unable to fulfill their obligations for reasons, such as imposition of exchange or other controls by the central bank or the government regulation, on which the parties do not have any control (externalization). Country risk is considered very high in the case of countries which are facing problems related to foreign exchange reserves, balance of payments, management of resources, liquidity etc.
Country risk is usually controlled by fixing country wise exposure limits and being dynamic, has to be constantly monitored, more particularly in case difficult countries. The difficult countries, may give high returns, as not too many countries, banks or parties wish to take exposure in such countries.
It would be worthwhile to mention that country risk is different from the usual credit and other risks associated with lending decisions, like credit risk, settlement risks, liquidity risk, etc.
A country risk arises, when the counter party or the borrower or the buyer is a good credit risk and does not have any desire to default but by local laws or directives, is forbidden by the government central
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bank to honour commitment. A sovereign risk is larger, when the counter party is the foreign government itself or any of its agencies, and enjoys sovereign immunity under the laws, with no legal recourse to other party. Another dimension of sovereign risk could be a change in the government policies, or the change in t government itself, which could invalidate the previous contracts and thus forbid the parties concerned to complete or take recourse for the same.
While sovereign risk cannot be completely avoided, when dealing with another country, it can be suitably reduced by inserting disclaimer clauses in the documentation and also making the contracts and the sovereign counter parties subject to a third country jurisdiction.
E. Interest Rate Risk
Interest rate risk or GAP risk, as it is otherwise known, arises due to adverse movement of interest rates or interest rate differentials. It also refers to the potential cost of the adverse movement of interest rates that the bank faces on its deposits/borrowings/lending, or the currency swaps, forward contracts, forward rate agreements, or other interest rate derivatives. The increasing capital flows in the global financial markets by the day, the economic disparities between the nations increased use of interest rates as a regulatory tool for macro-economic control to regulate global economies, have resulted in significant volatility interest rates.
While, in the course of its business, the bank buys and sells currencies for spot and forward value, borrows and lends foreign currencies, enters into swaps, futures or options relating to interest rates, it is not practically always possible match its forward purchase and sales, borrowing and lending, creating a mismatch between its assets and liabilities. This mismatch is referred to as GAP. These GAP’s are to be filled by the bank by paying/receiving appropriate forward differentials or resorting to other interest rate derivatives. The forward differentials are, thus a function of interest rates. Any adverse movement in Interest rates would result in adverse movement of forward differentials thus affecting the cash flows on the underlying open gaps or mismatches.
Besides, deployment of foreign currency resources is not exactly for matching maturities, exposing the bank to an interest rate risk due to uneven cash inflows and outflows.
Interest rate risk also occurs when different bases of interest rates are applied to assets and corresponding liabilities. If the degree of fluctuations in the two different interest rates is different, affecting the spread originally envisaged, then, interest rate risk is said to have occurred.
With the integration of foreign exchange and money markets, the dealers manage interest rate risks frequently by undertaking appropriate swaps, or matching funding actions or through appropriate risk mitigating interest rate deriatives.
To reduce interest rate risks, individual and aggregate gap limits are fixed for the international banking operations. Some banks adopt strategy to determine the interest rate scenario, undertake appropriate sensitivity exercises, for estimating the potential profit or losses based on interest rate projections and devise suitable hedging strategy and adopt various risk assessing models like value at risk, interest rate
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sensitivity test, etc., and use derivative products like interest rate swaps, currency swaps and forward rate agreements for managing the interest rate risk.
F. Operational Risk
Being a critical area of operations, operational risk is another important risk that should be managed by a dealing room. It may occur due to deficiencies in the information systems or internal control or human errors or other infrastructures problems that could lead to unexpected losses. Factors like trouble in the premises and location of the dealing room, the computer systems, hardware and software, communication systems including telephone lines, etc., provided to the dealing room fail to function due to some error or fault, the operations in the dealing room would come to a grinding halt and exposed to various risks.
Operational risk can be controlled by providing state of art systems, specified contingency plans, disaster control procedures, and sufficient back-up arrangements for man and machine, and a duplication process at a different site (mirroring).
G. Legal Risk
Legal risk arises when it transpires that the counter party, with whom the transaction has been undertaken, does not have the legal or regulatory authority to enter into such transaction. In other words, the counter party is incapacitated for engaging in such a deal, resulting in non-enforceability of contract. Legal risk also includes compliance and regulations related risks, arising out of non-compliance of prescribed guidelines or breach o governmental rules, leading to wrong understanding of rules and penalties by the enforcing agencies.
MANAGEMENT OF RISK AND GUIDELINES ON RISK MANAGEMENT
To manage risk, it is important to identify and appreciate the process of measurement of risks as a prerequisite. Some risks, like exchange risk, interest rate risk, etc., are easy to be quantified, while some other risks like country risk, operational risk, legal risk, etc., cannot be mathematically quantified and can only be qualitatively compared and measured. Some risks like gap risk in foreign exchange operations can be measured using modern mathematical and statistical tools like ‘value at risk’, etc. Thus only after the risk is identified and assessed, question of management of risk arises.
We have seen that risk is an unforeseen event, and to avoid risk proactive measures could be taken so as to either eliminate the same or reduce the same. Thus risk management is a process focusing upon steps to contain or avoid risks and losses there from. Since certain risks may not be avoided totally, its management would depend upon the expected rewards, risk appetite as also profile of the risk portfolio held.
A sound risk management process would start with a detailed policy, a specific limit structure for various risks and operations, a sound management information system, and specified control, monitoring and
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reporting process. Putting in place sound risk management policies, understood and laid down by the top management/board, would be a prerequisite for determining the risk exposures being faced by the bank. Measures to determine the market risks, credit or liquidity risks can be put in place in accordance with the laid down policies.
Thus the risk management process starts from the TOP, i.e. the Board of Directors, which should prescribe and approve a detailed policy for management of various risks being faced or expected to be faced by the bank. This policy would also specify limits for various types of trades, functions as also upper limits for exposures. All these limits would be based on the risk appetite of the bank in relation to the expected rewards in taking the risks. (Risk-reward equilibrium)
After the benchmarks are set out by the board, the top management has to involve in implementation of the plans, by putting in place required manpower, various infrastructure, tools, etc., to help the dealing staff in better functioning so as to avoid risks as also to measure and contain risks. The top management has not only to implement the policies approved by the board, but also ensure compliance of regulatory requirements.
The risk policy framework should cover the goals and objectives, delegation of responsibilities, specify activities to be undertaken and level of acceptable risks, besides the authority to undertake such functions and a system of review.
While implementing the risk policies, the top management has also to take appropriate measures to ensure proper and regular measuring and monitoring of the risks.
Risk management Policies require constant focus and attention and need to be reviewed on a regular basis. The natures of risks keep on changing with the business portfolio, also market scenario as also the tools, MIS, and risk containment measures. Risk management is dynamic and needs to remain in constant focus of the users as well as the top management.
The Guidelines
The broad policy approved by the Board of Directors and the steps for implementation taken by the top management would all be within the overall guidelines laid by the central bank of the country and/or other regulatory authorities. Reserve Bank of India and FEDAI have issued guidelines for management of risk in international trade and foreign exchange, which itself limit the risk in the forex operations.
RBI has issued Internal Control Guidelines (ICG) for foreign exchange business, which covers various aspects of dealing room operations, code of conduct for dealers and brokers and other aspects of risk control guidelines, including set up of the dealing room, back office, and risk management structure. Under ICG, banks are required to put in place various dealing limits for their forex operations, which can be briefly summarized as under:
i. Overnight limit: Maximum amount a bank can keep overnight, when markets in its time zone are closed.
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ii. Daylight limit: Maximum amount the bank can expose itself at any time during the day, to meet customers’ needs or for its trading operations.
iii. Gap limits: Maximum interperiod/month exposures which a bank can keep, are called gap limits.iv. Counter party limit: Maximum amount that a bank can expose itself to a particular counter
party.v. Country risk: Maximum exposure on a single country.
vi. Dealer limits: Maximum amount a dealer can keep exposure during the operating hours.vii. Stop loss limit: Maximum movement of rates against the position held, so as to trigger the limit
— or say maximum loss limit for adverse movement of rates.viii. Settlement risk: Maximum amount of exposure to any entity, maturing on a single day.
ix. Deal size limit: Highest amount of deal size a deal can be made, to restrict operational risk on large deals.
Besides above limits, banks approve panel of brokers through whom deals could be undertaken, the currencies in which the bank/dealers would deal in of Value of Risk limit, Nostro Balances limit, Overdraft limits, etc.
Further, the master circular on Risk Management and Interbank Dealings, issued by Reserve Bank of India, specifies risk management facilities that are available to residents and non-residents, to hedge their forex exposures, as also for authorized dealers, for managing exposures on their foreign currency assets and liabilities. The guidelines permit booking of forward contracts by customers on the strength of underlying exposure/transaction or merely on the basis of past at turnover. Also guidelines on interest rate swaps. Foreign currency and rupee options, etc., and the segments relating to Interbank dealings, procedures, norms for position and gap limits, authority to undertake FEX derivatives, foreign currency accounts, borrowing/lending in foreign currency and various reports to be submitted to the Reserve Bank of India are prescribed in the guidelines. Thus, while the RBI has prescribed the broad guidelines on operations and risk management aspects of FEX dealing room, detailed guidelines have been issued by FEDAI on certain aspects, while most of the guidelines and risk management framework is to be finalized and approved by the board of the bank, to be implemented by the top management, treasury head and the MID office functionaries.
Key learning
o Risk: Uncertainty
o Exchange Risk: It arises mainly on account of fluctuations in exchange rates and/ or when mismatches occur in assets / liabilities and receivables / payables
o Credit Risk: It is a risk of loss which arises due to inability or unwillingness of the counter party to meet the obligations at maturity of the underlying transaction.
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o Settlement Risk: it is the risk of the failure of the counter party during the course of settlement due to the time zone differences between the two currencies to be exchanged.
o Liquidity Risk: It is a risk which may arise due a party to foreign exchange transaction unable to meet its funding requirements or execute transaction at a reasonable price.
o Interest Rate Risk: Risk arising out of adverse movements in implied interest rates or actual interest rate differentials.
o Market Risk: It is a risk which arises due to a party to a foreign exchange transaction unable to exit or offset a position quickly at a reasonable price.
o Operational Risk: It is risk on account of human errors, technical faults, infrastructure breakdown, faulty systems and procedures or lack of internal controls.
o Legal Risk: It is a risk arising on account of non enforceability of contract against a counter party.
o Systemic Risk: This risk is possibility of a major bank failing and the resultant losses to counter party reverberating into a banking crises.
o Country Risk: It is the risk of the counter party situated in a different country unable to perform its part of the contractual obligations despite its willingness to do so due to local government regulations or political or economic instability in that country.
o Sovereign Risk: It is a sub category of country risk and arises on account of sovereign entities.
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UNIT 7BASICS OF DERIVATIVES
Learning objectives:
After studying this unit, you should be able to:
WHAT ARE DERIVATIVES HISTORY AND DEVELOPMENT DERIVATIVES IN INDIA — AN OVERVIEW DERIVATIVE INSTRUMENTS FORWARD CONTRACTS
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WHAT ARE DERIVATIVES — HISTORY AND DEVELOPMENT
As explained in the beginning of this unit, derivatives refer to a variable, which has been derived from another variable. Interest in derivative products may mostly arise out of Interest in the underlying product, but it can also be without any interest in the underlying. Even if so, the values of derivatives and the underlying are interrelated and irrespective of the fact that one has interest in both or only the later, the two will affect each other prices.
The underlying can be any product, literally anything ranging from agricultural products, foreign exchange, interest rates, oil, gas, gold or silver, stocks and stock indices, financial instruments (Treasury Bills, Bonds, etc.) or anything in the world, which itself is traded. Thus derivatives are derived from markets, products, risks or any underlying on which they are based.
Derivatives have been in use for hundreds of years, in the form of futures or options, when high seas cargoes were bought and sold in future prices (or priced for future delivery) or rice produce sold for future delivery by Japanese farmers. The future transactions were then done in various pockets, in anticipation of future deliveries. The explosion of the market could be linked to or coincided with the collapse of Bretton Woods fixed exchange rate regime (35 USD = 1 Ounce of Gold) and suspension of US Dollars’ direct, links to gold in the 1970s. The delinking of US dollars to a fixed parity of gold, effected volatiIity of exchange rates as also the interest rates. The increased volatility thus lead to the creation and explosion of a financial derivatives market which has since than grown manifolds.
In early 1970s, the Chicago Mercantile Exchange introduced the world’s first exchange traded currency future contract. Later in 1975, the first interest rate futures were introduced. Several exchanges then introduced exchange rate and interest rate futures contracts. By 1983, the derivative markets saw further growth with currency options trading in Philadelphia Stock Exchange.
Trading in Currency Futures and options gave the world a whole new range of risk management techniques for managing exchange risk, which helped in growth of global trade, investments and cross-border remittances.
This was the time (early 1980s) when interest rate swaps were also introduced. Interest rate swaps helped borrowers and lenders to switch their borrowings/lendings from fixed to floating rate structures are otherwise, as per their views on the interest rate movements.
Mid-1980s saw a boost in the derivatives market, with a host of exchange rate, interest rate as also commodity price risk derivative tools/products being traded in various exchanges, which was evident from the fact that Chicago exchange handled millions of derivatives contracts annually.
Initially, the derivative products were used mainly by the hedgers as actual users of the underlying contracts, who used these products for managing their risks. The importers, exporters, financiers, borrowers, buyers, etc., were the major users of these products.
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Gradually, individuals and institutions tracked the prices of derivative products, much similar to speculation in commodity prices or cross currency prices. They started speculation in futures, options and swap prices. This gave depth and volumes to the derivative markets.
Further, there were people who would be always on a look out for, opportunities of mispricing and uneven pricing on the markets, and arbitraged between market differences, until the differences disappeared.
Thus, hedgers, speculations and arbitrages provided depth, volumes and initiative for newer derivative products, so that a large number of exchanges offered these products with spurt in volumes by the day. The derivative products in a short lifespan of 25 years, have seen tremendous growth, which can be observed from the fact that in April 1988, the average daily turnover in derivatives was to the order of USD 1.3 trillion while, the notional amounts outstanding for OTC contracts and exchange traded contracts stood at USD 72 trillion and USD14 trillion respectively in June 1998. (BIS Data):
The main reasons for this growth in derivatives market were increased volatility in the financial and commodity assets during 1970 and 1980s, the oil shocks, in 1971 and thereafter, the need to insulate exchange risk for incomes in different currencies, arising out of increased global investments, technological advancements providing real-time information systems and 24-hour financial trading platforms, also development of pricing models and instruments based on computer-generated work sheets, the political developments and not the least but the most important would be increasing professionalism amongst all market participants, be it banks, traders, actual users, companies, investors, etc.
Derivatives in India — An Overview
Derivatives are not new for India, and have been practiced for several years, in commodities markets, like oilseeds, jute, etc., as also as Badla system in the stock market. The use of modern financial derivatives started in 1990s in forex, capital and commodities markets. While in 1992., Reserve Bank of India had permitted banks to offer cross currency options to their clients, on back to back basis, in 1996 banks were allowed to offer to their corporate rest rate swaps, currency swaps, coupon swaps, interest rate options, and FRAs. Further, banks are also allowed to use these derivatives to manage risks of their assets and liabilities, and also for ALM purposes.
On, the other hand, derivative products were allowed for capital markets in 2001, with futures and options being offered on BSE and NSE, for stock indices also for individual stocks.
Later on derivatives were also permitted in commodities market, with forming specific commodity exchanges, NCDEX and MCDEX, offering derivatives of various commodities such as pepper, soya, cotton, gold, silver, sugar, etc. Derivatives are picking up in the Indian markets, as market participants get savvy in its understanding, use and deriving benefits out of the products on offer. The market in India is slated to grow manifold, which can be judged from fact that the principal amount of IRS outstanding has crossed a figure of over Rs 2,00,000 crore and the daily turnover in the stock exchanges in derivative segments is almost equal to the cash segments, on several of the trading days.
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DERIVATIVE INSTRUMENTS
Types and Classification
As made to understand earlier in this chapter, derivative instruments are management tools derived from underlying exposure such as currency, commodities, shares, bonds or any of the indices, used to reduce or neutralize the exposures on the underlying contracts. Derivatives help to hedge against the uncertain movements in the prices of the underlying contracts.
Derivatives could be Over the Counter (OTC) i.e. made to order (suited to ones’ needs or requirements) or Exchange Traded Facilities which are for fixed lots, periods/tenors, etc.
OTC products are customized for the amount, period, etc., and are flexible to suit the needs of the customers. OTC derivatives are mainly offered by banks and Fls, exchange traded products are traded on the floor of the exchanges and are standardized in terms of quantity, quality, start and ending dates. Due to standardization of products, exchange traded derivatives are lesss expensive in comparison to the OTC products.
Forward Contracts
Forward contracts are typical OTC derivatives involving the fixation of rates (Exchange rate, commodity price, etc.) in advance for deliveries in future. In a forward contract a seller agrees to deliver goods to the buyer on some future date at a fixed rate. Forward contracts has a long history with the earliest forward contract reported to have undertaken at Chicago Board of Trade in 1851 for delivery of maize corn.
Under forward contract, since the price of commodity or foreign currency is fixed today for delivery on a future date, the risk of any adverse price movements is removed on covered.
Thus forward contracts are a firm and binding contracts entered into by two parties (usually the user and bank/institution/exchange), for purchase or sale a specified quantity of foreign currency or commodity. (Gold, silver, metal, etc.) at an agreed price for delivery and payment at a future date or in certain cases during a period of specified time.
The rate specified for the forward contract is called forward rate, it is generally quoted as premium or discount over the cash/spot rates.
The forward premium/discount applicable for the forward rate/price is merely the cost of carry of the commodity or the currency price, and includes say the storage cost, insurance cost, interest cost, etc. The forward rate/price is a function of spot price plus cost of carry.
In currency/exchange forwards, the cost of carry would depend upon the interest rate differential of both the currencies being exchanged.
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The forward exchange rate may be equal to, higher/costlier or lower/cheaper than the spot rate of the currency, based- on the interest rate of one currency in relation to another.
The currency with lower interest rate would be at a premium in future, while the currency with a higher interest rate would be at a discount in future. The forward exchange rate would thus be a function of spot rate plus or minus premium/discount as the case may be.
Forward contracts could be fixed date forward contracts or option period forward contracts. In international foreign exchange market, all forward contracts are usually on fixed date delivery basis, say, one month, 3 months, 6 months forwards, from spot date and forward date of delivery is fixed at the time of entering into the contract itself.
Let us now see how forward exchange rates are calculated:
A forward rate is the price the market sets for the currency today for the delivery on a future date.
In forex markets, the forward rate is a function of spot rate and premium/discount of the currency. The premium/discount would depend upon mainly on interest rate differential of the two currencies, but also on the demand/ supply of the currency for future deliveries, the perception, the political, fiscal and other trade-related conditions in the country and for the currency.
In a pure market, the forward differentials should be almost equal to the interest rate differentials of the two currencies being dealt with.
Key learning
o Derivatives: They are hedging instruments
o Forward Contract: It is binding contract for purchase / sale at a future date.
o Premium / Discount: It represents interest rate differential in a forward contract.
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UNIT 8DERIVATIVE INSTRUMENTS - FUTURES
Learning objectives:
After studying this unit, you should be able to:
FUTURES – KEY FEAUTRES FUTURES VS FORWARDS THE MARGIN PROCESS
O INITIAL MARGINO VARIABLE MARGINO MAINTAINCE MARGIN
Futures
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Another most popular and widely used derivatives product is futures, which was evolved out of forward contracts. Futures could be called another version of exchange traded forward contracts, which is based upon an agreement to buy or sell an asset at a price at certain time in future. Futures are standardized contracts as far as the quantity (amounts) and delivery dates (period) of the contracts.
A future contract conveys an agreement to buy a specific amount of a commodity or financial instruments at a particular price on a stipulated future date. It is an obligation on the buyer to purchase the underlying instrument and the seller to sell it, unless the contract is sold to another person/entity in order to take profit or book/limit the loss.
Let us now see the key features of the future contracts.
1. It standardizes the quality of underlying asset per contract, known as contract size. It is also called Notional Principal Amount.
2. It standardizes the minimum price movement for the contract known as tick size, say for GBP/USD one basis point.
3. The-period of contract is also standardized — say three months starting/ending in calendar quarter month of March, June, September and December.
4. Futures are exchange traded contracts and hence the buy/sells contracts are between the futures exchange and the buyer or seller and not directly between buyers and sellers. The exchanges are in the middle of each contracts.
5. Futures exchange maintains creditworthiness, by way of margin on buyer and sellers, which is adjusted each day.
6. The delivery under future contract is not a must, and the buyer/seller can set off the contract by packing the difference amount at the current rate/price of the underlying.
The Futures are thus a type of forward contract, but differ from forwards in several ways. The difference between the two can be listed as under:
Futures Forwards
1. An exchange traded contract An OTC product
2. Standardized amount of contract Can be made for any odd amount based on need3. Standardized time period, say three months, six months, etc.
Can be made for any odd periods, say one and a half month or 100 days etc.
4. Delivery of underlying not essential Delivery is essential
5. Contract risk on exchanges, i.e. performance guaranteed by Exchanges
Credit risk on counter parties, i.e. buyers and sellers.
6. Works on margin requirements, and are marked to market every day.
Margins not compulsory. Not marked i.e.to market Every day.
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The Margin Process: From the above, it can be seen that the backbone and creditworthiness and capacity of exchanges to settle the contracts is based on margin mechanism. Future contracts are marked to marked on daily basis and are thus similar to daily settled forward contracts. Three types of margins are levied in a futures contract.
1. Initial margin: At the start of each new contract initial margin is to be paid to the Exchange in the form of cash or another approved liquid security (i.e. treasury bills, bonds, bank guarantees). It is usually a small margin, which enables the buyers as seller to command and play in a large value of contract. For example, in London International Financial Futures Exchange (LIFFE) initial margin for a Euro/Dollar Contract size of USD 1 million is USD 500 only. Thus any person with only USD 500 can play/enter into a large value future contract of USD 1.00 million.
2. Variable margin: It is calculated on daily basis, by marking to market the contract at the end of each day. This margin is normally to be deposited in cash only. Any adverse movement in the value of the underlying asset is thus to be deposited in cash to cover the increased credit risk. The exchange makes the margin call, upon erosion in value of the contract which is normally to be deposited and made available in the margin account with the exchange by next morning. In case of appreciation in value of the contract, the difference occurs to the buyer and the same is credited by the exchange to this margin account.
3. Maintenance margin: This margin is similar to minimum balance stipulation for undertaking and trades in the Exchange and has to be maintained by the buyer/seller in the margin account with the exchange. The exchange is also authorized to debit/credit the variable margin to this amount as such the party needs to constantly fund the account in case of continuous erosion in the value of contract.
Let us now see an example of a future contract in euro dollar to see the movment of margins in a futures contract
Euro—Dollar Contract for Notional Principal amount of Euro 1 million
tick size 1 basis point, period 3 months
Tick size of 0.0001 would be equivalent to Euro 25.00 as under:
Notional principal x tick size x Period (annualized)
1000,000 x 0.0001 x 3/12 = Euro 25.00 in per tick movement
Say the contract was BOT on 1.404 at EURO/USD base spot price of 1.2700 and future rate of 1.3000 value 30.6.04.
The buyer has deposited Euro 500 as initial margin and Euro 2000 as maintenance margin with the exchange. (Minimum balance).
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Say on 2.4.04, the spot price moves to 1.2690 (movement of 10 pips) against the buyer his maintenance account will be debited by Euro 250.00 (10 pips x 25.00) which he has to replenish to maintain the minimum balance.
The spot price moves to 1.2710 on 3.4.04 the exchange will credit (20 x 25) Euro 500.00 to his margin A/c and he can now withdraw Euro 250.00 in excess of the minimum margin in his account.
Futures contracts can mainly be of four major types:
— Commodity futures
— Financial futures, including interest rate futures
— Currency futures
— Index futures
The futures contracts were first traded in 1972 Chicago Mercantile Exchange and the future market has seen tremendous growth over the past decades, both in terms of usage, number of instruments as also geographically.
Key learning
o Futures: It is a contract traded on an exchange to make or take delivery of a commodity.
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UNIT 9DERIVATIVE INSTRUMENTS - OPTIONS
Learning objectives:
After studying this unit, you should be able to:
OPTION ISA RIGHT NOT AN OBLIGATION CALL OPTION / PUT OPTION OPTION PREMIUM IN THE MONEY, AT THE MONEY, OUT OF THE MONEY AMERICAN OPTION/ EUROPEAN OPTION
Options
Under the forward contract or the futures, delivery of contracts or its reversal at the prevailing price, is essential and as such any favourable movement of price index would not be beneficial to the purchaser/corporate. To overcome this essential feature, options were invented, where the buyer had an option to buy or sell the underlying without any obligation.
The options convey the right to buy or sell an agreed quantity of currency commodity on index value, at an agreed price, without any obligation to do so.
Thus option is a right not an obligation.
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The option holder or buyer would exercise the option (buy or sell) in case the market price moves adversely and would allow the option contract to lapse in case the market price is favourable than the option price.
On the other hand, the option seller, usually a bank or financial institution or an exchange is under obligation to deliver the contract, if exercised at the agreed price, but has no right to revoke/cancel the same.
Options are traded in exchanges, where the counter party is the Option Exchange.
Options conferring a right to buy at a fixed price on or before a fixed date are called Call option, while options conferring a right to sell at a fixed price or before a fixed date are called Put Option.
The price at which the option may be exercised and the underlying asset bought or sold is called Strike Price or Exercise Price.
The cost of the option, usually levied upfront on the buyer of the option, called premium. This is the fees to buy the option contract (akin to insurance premium). The final day on which option may be exercised, is called Maturity date or expiration date.
In the money: When the strike price is below the spot price, in case of a call option or when the strike price is above the spot price in case of a Put Option, the option is in the money, giving gain to the buyer of the option to exercise the same.
At the money: When strike price is equal to the spot price, the option is said be at the money leaving no gain or loss to utilize the option.
Out of the money: The strike price is below the spot price in case of put option and above the spot price in case of call option, the option is said to be out of the money. It is better to let the option expire without use, in case the option is out of the money.
Options are of two types, when seen from delivery/expiry angle:
1. American option: can be exercised on any date before and including (the expiry date).
2. European option: can be exercised only at maturity date (fixed date).
The option contract insures the buyer against worst case scenario and allows him to take advantage of any favourable movement in the spot rate. Options are both OTC products as well as exchange traded, most popular being currency options, which are traded on many exchanges of the world. Other options are stock options, commodity options, index options, etc. We may now see the working of an option, in the example of currency on as under:
Example
Say in case of USD/Re on 1.10.09 an exporter has a receivable of USD 1million value 6 months, i.e. 1. 4 .10. The spot USD/Re is 45.00.
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Now due to uncertain market, he feels that the rupee may weaken six months down the lane, and he does not deem it fit to lock his chance of any upside, by booking forward contract. On the other hand, the market could go other way, if large inflows continue. He is able to get a Put Option for USD at 45.50 value 1. 4. 10 at a premium of 0.05 paise per USD. Due to this contradiction in views, he feels that it is prudent to buy a Put Option at a strike price of 45.50, at a premium of 5 paise per USD, instead of booking forward contract at 45.50.
On the expiry date, i.e. 1. 4.10 the spot USD/Re is 46.05, he allows the option to expire and sell his USD in the market at 46.05 getting 50 paise (after adjustment of premium cost).
He has thus taken a chance to avail upside by bearing a small cost in the form of premium, and thus insured the value of his USD earning at 45.45(45.50 — 0.05) on one hand and on the other hand, retained right to avail the advantage of any market move in his favour beyond the strike rate.
The pricing of option premium is based on several factors. There are several methods an approaches of pricing of options such as Binomial theory, Cox-Rubentstein, Garman and Kohlagen theory, and the Block Scholes model which e most popular of all.
Option pricing would depend upon the following aspects:
Call and Put Option Amount (Whether market lot or small lot) Strike price Type — American or European Spot rate Interest rate differentials Swap rate (forward differentials) Volatility in the price of the underlying.
The tricky issue of option pricing is complicated due to effect of several factors listed above, as such computation of the option price is done normally on the basis of computer models.
However, volatility in price of underlying is the most important feature and the option price is directly affected by the same, i.e. higher the volatility, higher would be the price.
Options are widely used in foreign exchange markets, where both OTC and exchange traded options are available. Equity and commodity linked options are usually exchange traded only. Options are also available on various exchanges for hedging interest rate risk.
Options are also available on futures contracts, giving a double edged sword in the hands of the buyer. The buyer has an option to exercise the rate fixed in the futures constant, thereby allowing flexibility in the futures contract.
Key learning
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o Option: Contracts confer upon the holder the right without the obligation to take up the contract.
o Premium: In an option contract represents the fee charged by the option writer
o Call Option: Option conferring a right to buy at a fixed price on or before a fixed date is called call option.
o Put Option: Option conferring a right to sell at a fixed price on or before a fixed date is called put option.
o Strike Price: The price at which the option may be exercised and the underlying asset bought or sold is called strike price or exercise price.
o In The Money: When the strike price is below the spot price, in case of call option or when the strike price is above the spot price in case of a put option the option is in the money, giving gain to the buyer of the option to exercise the sale.
o At The Money: When the strike price is equal the spot price, the option is said to be at the money leaving no gain or loss to utilize the option.
o Out Of The Money: The strike price is below the spot price in case of put option and above the spot price in case of call option the option is said to be out of the money.
o American Option: Can be exercised on any date before and including the expiry date.
o European Option: Can be exercised only at maturity date (fixed date).
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UNIT 10DERIVATIVE INSTRUMENTS - SWAPS
Learning objectives:
After studying this unit, you should be able to:
INTEREST AND CURRENCY SWAPS DEFINITION COMPARITIVE ADVANTAGE ASSET AND LIABILITY MANAGEMENT INTEREST RATE SWAPS CURRENCY SWAPS
INTEREST RATE AND CURRENCY SWAPS
A swap represents an exchange of obligations. There are two principal types:
• Interest rate swap, which is an interest rate derivative, and
• Currency swap, which is a derivative on a currency pair.
Some of the reasons for which swaps are entered into are as follows:
Comparative advantage
A company or a bank may have a particular advantage, in terms of lower borrowing cost, compared to another company/bank in the fixed rate market. However, that entity may want to borrow on a floating basis. Similarly, another company may have an advantage in borrowing on a floating basis but wants to
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borrow on a fixed basis. The companies will, therefore, borrow in markets where they have a comparative advantage and then swap their obligations to create the desired exposure.
Asset and liability management
In any large financial institution the continuous creation of assets and liabilities of varying maturities and different currencies makes it necessary to manage the interest rate risks continuously. Swaps are an important tool to change the interest and currency profile of its portfolio. In some ways the swap completes the gaps in the market by creating availability of securities for various maturities. By using swaps, risks may be shifted in ways that otherwise are not available.
For example, suppose a Japanese company, which is heavily into exports to America and thus has dollar earnings, wants to take a loan in USD. If it is not well known abroad, it may find it difficult to raise a cost-effective dollar loan. But it may be able to take a yen loan effectively. On the other hand, there could be an American company that is in exactly the opposite situation. A bank can bring these two parties together and arrange for an exchange of their respective borrowings/obligations.
INTEREST RATE SWAPS
In the case of interest rate swaps, interest payment obligations are exchanged between two parties, and both the obligations are denominated in the same currency. The most common swap is the fixed to floating rate swap. For example, a company with a fixed rate loan may wish to convert its obligation to a floating rate one. There may be another company that wants to convert its floating rate obligation into a fixed rate loan. The two may agree to swap their obligations. Here there is no transfer of principal. It is just notional. Only the net interest obligation is exchanged, normally every six months. The party that owes more interest than it receives makes the net payment to the other party.
Normally the arrangements are done through an intermediary— a bank or financial institution. The floating rate payments are generally linked to LIBOR.
Another form of interest rate swap is the basis swap or floating to floating swap. Here, two floating rate obligations are exchanged where the two obligations are based on different basis— for example an obligation with LIBOR as reference rate can be swapped with one using Treasury bill rate as a reference rate.
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Fig.: Interest rate swap
Interest rate swap markets In India
The interest rate swap market in India started only in 1999-2000. The market is still very small as compared with international standards. Not all banks are active in this market. One limitation of the rupee market is the absence of an offshore (or euro) rupee market, which can offer an interbank yield curve for rupees not affected by statutory requirements.
The common benchmarks used in India are:
MIBOR: Mumbai Interbank Offered Rate—basically the interbank call money rate.
MITOR: Mumbai Interbank Tom Offered Rate—calculated from the overnight USD interbank offer rate and annualized cash- tom premium.
MIFOR: Mumbai Interbank Forward Offered Rate—calculated from USD interbank offer rate for the relevant period and the annualized forward premium for the same period.
The most popular interest rate swap in the Indian market is the Overnight Index Swap (OIS) where the floating rate is linked to an overnight interbank call money index. There is no restriction on the tenor of the swap. The interest is computed on a notional principal amount and settled on a net basis at maturity. On the floating rate side, the interest amounts are compounded on a daily basis based on the index. The most popular benchmarks are NSE 0/N MIBOR and the Reuters 0/N MIBOR.
CURRENCY SWAPS
In the case of currency swaps, two parties exchange principal and interest obligations on debt denominated in different currencies. At maturity the principal amounts are re-exchanged, usually at a rate of exchange agreed upon in advance.
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Fig.: currency swap
Currency swaps involve an exchange of cash flows in two different currencies. Therefore, an exchange rate, generally the prevailing spot rate, is used to calculate the amount of cash flows, apart from interest rates relevant to these two currencies.
Difference between Interest rate and currency swaps
An interest rate swap involves only one currency whereas a currency swap will involve two currencies.
In interest rate swap only the interest flows are exchanged but in currency swaps the principal also gets exchanged.
Currency swaps can have fixed interest rates for the two different currencies, which is not possible in interest rate swaps.
Currency swan markets in India
The currency swap market is also a small market in India averaging about USD14O million per day. For cross currency swap (without INR) the banks act as intermediaries between international markets and corporate customers here, doing the transactions on back to back and fully hedged basis. Banks in India also run books on USD/INR swaps with certain limitations.
FIMMDA gives indicative rates based on market polling for interest rate and currency swaps. MIOCS—Mumbai Inter Bank Offered Currency Swap—for USD/INR is a benchmark given by FIMMDA based on market polling.
Key learning
o Swap: It is an exchange of specific streams of payments over an agreed period of time.
o Currency Swaps: Exchange of Pre determined streams of payments in different currencies on pre determined dates, at pre determined exchange rates.
o Interest Rate Swaps: Exchange of different streams of interest structures there would be no exchange of principle amounts under interest rate swap and only interest streams would be exchanged.
o Coupon Swaps: Were fixed interest rates are swapped with the floating interest rates
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UNIT 11Hedging FOREIGN EXCHANGE RISK
Learning objectives:
After studying this unit, you should be able to:
INTRODUCTION HEDGEING HEDGEING INSTRUMENTS
O SHORT TERM HEDGEINGO LONG TERM HEDGEING
SPECULATION ARBITRAGE
INTRODUCTION
The primary activities in the forex market are buying and selling of currencies in the spot and forward markets.
Corporations, all over the world, tend to be exporters or importers, or borrowers or investors in foreign currency. Their exposure to foreign currency leads to foreign exchange risk.
For example, an Indian exporter to the US risks future depreciation of USD, while an Indian importer from US risks future appreciation of USD. Borrowers in foreign currency face similar risks.
HEDGING
Uncertainty in the value of receivables/payables denominated in foreign currencies, due to exchange rate movement, generates exchange risk. Hedging in the foreign exchange market is the avoidance or elimination of risk. The purpose of hedging is loss minimization, not profit maximization. In other words, it is a nonprofit centered activity.
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Hedging is achieved by avoiding open Positions in foreign exchange, i.e. the imbalances in assets and liabilities denominated in foreign currencies.
A long position arises when foreign currency assets exceed foreign currency liabilities. A short position arises when foreign currency liabilities exceed foreign currency assets. Both positions involve exchange risk, because these open positions expose the holder of assets and liabilities to potential losses resulting from adverse movements in foreign exchange rates.
A spot depreciation in foreign currency against domestic currency reduces the value of assets or liabilities denominated in foreign currency. Similarly, an appreciation of foreign currency increases their value.
Losses due to depreciation and appreciation can be avoided by hedging in the foreign exchange market through a forward sale/purchase of these assets or liabilities.
For example, an Indian resident expects to receive GBP 2000 after three months. The anticipated sum is Rs.160, 000 at the rate of GBP 1 = Rs.80 (spot rate). Suppose GBP is expected to depreciate against rupees in three months to GBP 1 = Rs.75, he will lose Rs.10, 000. But if the forward rate is Rs.78, and he buys a forward contract, i.e. he hedges, and then the loss is reduced to Rs.4, 000. Moreover he eliminates the uncertainty of cash flows totally. Whatever may be the spot rate after three months, he will be able to convert GBP into INR at Rs.78 per GBP.
HEDGING INSTRUMENTS
Foreign exchange exposures may be created for a short term or long term. Hence, hedging is done either short-term or long-term. The instruments of hedging are different for each type.
Short-term hedging
Hedgeding for a short-term duration can be done through:
Currency forwards Currency futures Currency options
Long-term hedging
Hedging for a long-term duration can be done through:
Long-term forward contracts Currency swaps Parallel loans Leading and lagging payments
SPECULATION
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Acceptance of foreign exchange risk is speculation. It is the opposite of hedging. Speculation is a difficult trading technique because one has to identify, with a high degree of reliability, the movement in exchange rate so that one can benefit from this trading.
Speculation refers to deliberate creation of a position in order to profit from exchange rate fluctuations, accepting the added risk. This is a deliberate attempt to benefit from the exchange rate movement. Consequently, an open foreign exchange position is based on speculation. These positions may be long or short, but they involve risk and hence the possibility of speculative gains.
Speculators are those investors who willingly take price risks to profit from price changes in the underlying asset. Speculators do not have any position in the underlying cash market on which they enter into futures and options market. They just have a view or belief about a commodity, currency, stock index, interest rate, etc., that is based on policy announcements by the government, international events or any other development.
They may be either bullish or bearish on any currency. Their outlook is said to be bullish when they buy futures or call (sell put options) options and wait for the prices to rise in future. It is said to be bearish when they take an opposite view, i.e. they sell futures or call options (buy put options) and hope for prices to fall so that they can buy the currency and deliver.
Speculators are essential to foreign exchange markets as they provide volume and liquidity. They act as a counter party to the hedgers. Internationally, speculation in currency trading is quite large. Large fluctuations in currency widen the scope for speculators.
Speculation may be conducted through either the spot or forward exchange markets and involves the establishment of short positions in weak currencies, which are expected to depreciate or be devalued, and long positions in strong currencies, which are expected to appreciate or be revalued.
By far, the largest proportion of currency exchange transactions in the international forex markets is speculative in nature. That is, currencies are bought and sold in the hope of profiting from price movements. Indian exchange control allows banks in India to undertake currency trading within approved limits. Recent relaxations in exchange control in India permit non-bank entities in India also to speculate on currency movements. This is done in three ways:
1. By canceling and re-booking of forward contracts: To be sure, the initial booking of a forward contract to sell or purchase a currency against the dollar or rupee can be done only to hedge a commercial exposure. Consider a euro payable. You buy Euros in the forward market against dollars as a trading position at USD 1.2695. Your expectation that the euro is likely to appreciate proves right and you cancel the contract at USD 1.2750. This difference is not a profit, as you still have to buy Euros to honor the payable. There will be profit only if you succeed in re-buying Euros at a rate better than USD 1.2750, perhaps USD 1.2725. Remember that under the strategy of canceling and rebooking forward contracts, the profit is not the gain on cancellation of the original contract; it is the difference between the cancellation and re-booking rates.
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2. By booking a forward contract in a currency other than the actual exposure: For example, a dollar payable can be hedged by buying dollars against Euros. As a careful reading of the earlier discussion shows, this is not a hedge at all. The dollar exposure against rupee has been changed to a euro exposure against the rupee.
3. By locking into the forward premium when it is attractive, but the spot rate is not.
ARBITRAGE
The act of purchasing a currency security or commodity in one market and selling it immediately in another at a higher price is termed arbitrage, or specifically, deterministic arbitrage. It means taking advantage of discrepancies in the prices of currencies or commodities existing in various markets at the same or at different times.
However, the meaning of arbitrage has been expanded to include any activity wherein the difference of pricing is exploited. Arbitrage is popularly applied in trading options and futures. Risk-free profits continue until market correction occurs.
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UNIT 12REGULATORY FRAMEWORK
Learning objectives:
After studying this unit, you should be able to:
REGULATORY FRAMEWORK THE RESERVE BANK OF INDIA FOREIGN EXCHANGE DEALER’S ASSOCIATION OF INDIA IMPORTANT REGULATORY GUIDELINES FOR
O RESIDENTS OTHER THAN AD’SO FOREIGN INSTITUTIONAL INVESTORS (FII)O NON RESIDENT INDIANS & OVERSEAS CORPORATE BODIESO FOREIGN DIRECT INVESTMENTS (FDI)O FOREX FACILITIES FOR RESIDENTS (INDIVIDUAL)
REGULATORY FRAMEWORK
The regulatory framework for foreign exchange markets in any country is generally decided by the central bank of that country. In India, the Reserve Bank of India (RBI) decides the rules of the game for the way foreign exchange markets function. The participation of central banks in the foreign exchange markets for stabilizing exchange rates is very important because this infuses confidence in the functioning of forex markets. Apart from RBI, the Foreign Exchange Dealers Association of India (FEDAI) plays an important role in the development of foreign exchange markets in India.
The Reserve Bank of India
The RBI is entrusted with monetary stability, the management of currency and the supervision of the banking as well as the payments system.
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RBI manages the foreign exchange operations through two departments, namely:
• Department of External Investments and Operations, and• Foreign Exchange Department.
Department of external investments and operations
The main activities of the department are management of exchange rate of the Indian rupee, and management and investment of foreign exchange reserves of RBI. This primarily involves the following.
Exchange rate management
The day-to-day movements in exchange rates are market determined. The primary objective of RBI is to maintain stability in the foreign exchange market, meeting temporary supply-demand gaps that may arise for various reasons, and curbing destabilizing and self-fulfilling speculative activities. To this end, RBI closely monitors developments in the financial markets at home and abroad and carefully coordinates its market operations with appropriate monetary, administrative and other measures as it considers necessary from time to time.
Reserves management
The essential framework for reserves management as regards currency, market and instruments for investment are provided in the Reserve Bank of India Act 1934. The overall stance of RBI’s reserve management policy continues to be risk averse aiming at stable returns. The principal objectives behind its approach continue to be safety and liquidity. Within these parameters, return optimization dictates operational strategies.
Foreign exchange department
With the introduction of the Foreign Exchange Management Act 1999 (FEMA) with effect from June 1, 2000, the objective of the Foreign Exchange Department has shifted from conservation of foreign exchange to “facilitating external trade and payment and promoting the orderly development and maintenance of foreign exchange market in India” [Source RBI web site].
FOREIGN EXCHANGE DEALER’S ASSOCIATION OF INDIA
A self-regulatory body, FEDAI was set up n 1958 as an association of banks dealing in foreign exchange in India (typically called ADs). Its major activities include framing of rules governing the conduct of interbank foreign exchange business among banks in relation to the public, and liaisoning with RBI for reforms and development of the forex market.
Presently some of the functions are as follows:
Setting guidelines and rules for forex business Training of bank personnel in the areas of foreign exchange business
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Accreditation of forex brokers Advising/assisting member banks in settling issues/matters in their dealings Represent member banks on government/RB I/other bodies Announcement of daily and periodical rates to member banks
REGULATORY FRAMWORK FOR FOREIGN EXCHANGE IN INDIA
The following section briefly lists down regulatory guidelines for
1. Residents other than ADs2. Foreign Institutional Investors3. Non-Resident Indians and Overseas Corporate Bodies4. Foreign Direct Investment5. Interbank foreign exchange dealings
Residents other than AD’s
Forward contracts
1. A person resident in India may enter into a forward contract with an AD in India to hedge an exposure to exchange risk, arising out of a genuine permitted transaction. The terms are as follows:
a. The maturity of the hedge does not exceed the maturity of the underlying transactionb. Customer can choose currency of hedge and tenorc. If the exact amount of the underlying transaction cannot be ascertained, the contract is
booked on the basis of a reasonable estimated. Cancellation and re-booking of forward contracts, booked in respect of foreign currency
exposures of residents falling due within one year, and all contracts booked to cover export transactions are allowed. Forward contracts booked to cover exposures falling due beyond one year, once cancelled cannot be re-booked. ADs may continue to offer this facility without any restrictions for export transactions. Roll over of all forward contracts may take place at ongoing market rates.
e. ADs may permit substitution of contracts for hedging trade transactions if the circumstances warrant it.
2. A forward contract cancelled with one AD can be re-booked with another subject to the following conditions:
a. Competitive rates on offer, termination of banking relationship with the authorized dealer with whom the contract was originally booked, etc., warrant the switch
b. Simultaneous cancellation and re-booking are done on the maturity date of the contract.
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3. Residents are permitted to hedge the exchange risk of overseas direct investments (in equity and loan) by booking forward contracts with ADs. Contracts covering overseas direct investments have to be completed by delivery date or rolled over on the due date and cannot be cancelled.
4. ADs may also enter into forward contracts with residents for transactions denominated in foreign currency but settled in Indian rupees. These contracts are held till maturity and are cash settled on the maturity date by canceling the contracts. Once cancelled, these contracts cannot be rebooked.
REGULATIONS FOR FOREIGN INSTITUTIONAL INVESTORS
Forward cover—with rupee as one of the currencies—may be provided by ADs to foreign institutional investors (FlIs) subject to the following:
a. FIls are allowed to hedge the market value of their entire investment in equity and/or debt in India as on a particular date. If a hedge becomes naked in part or full owing to shrinking of the portfolio, for reasons other than sale of securities, the hedge may be allowed to continue to the original maturity, if so desired.
b. Once cancelled these forward contracts cannot be re booked, but may be rolled over on or before maturity.
c. The cost of hedge is met out of repatriable funds and/or inward remittance through normal banking channels.
The eligibility for cover may be determined on the basis of the declaration of the FlI.
REGULATIONS FOR NON-RESIDENTINDIANs (NRIs) AND OVERSEAS CORPORATE BODIES (OCBs)
ADs may enter into forward contracts with non-resident Indians (NRIs)/overseas corporate bodies (OCBs) as per the following guidelines to hedge:
a. The amount of dividend due on shares held in an Indian company.b. The balances held in the Foreign Currency Non-Resident (FCNR) account or the Non-Resident
External Rupee (NRE) account. Forward contracts with the rupee as one of the legs may be booked against balances in both the accounts. With regard to balances in Foreign Currency (Non-Resident) [FCNR(B)] accounts, cross currency forward contracts (not involving the rupee) may also be booked to convert the balances in one foreign currency to another in which FCNR(B) deposits are permitted to be maintained.
c. Forward cover cannot be provided on NRE saving and current accounts as they are payable on demand.
d. The amount of investment made under portfolio scheme.
HEDGING FOREIGN DIRECT INVESTMENT IN INDIA
ADs may enter into forward contracts with residents outside India to hedge investments made in India since January 1, 1993, subject to verification of the exposure in India.
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Residents outside India who have foreign direct investment in India are permitted to enter into forward contracts with ADs with rupee as one of the currencies to hedge the currency risk on dividend receivable by them on their investments in Indian companies.
Residents outside India may also enter into forward sale contracts with ADs to hedge the currency risk of their proposed foreign direct investment in India. Such contracts may be booked only after ensuring that the overseas entities have completed all the necessary formalities and obtained necessary approvals (wherever applicable) for the investment. The tenor of the contracts cannot exceed six months; beyond that RBI permission is required to continue with the contract. These contracts, if cancelled, cannot be re-booked for the same inflows, and exchange gains, if any, on cancellation cannot be passed on to the overseas investor.
Note: All foreign exchange derivative contracts permissible to a person resident outside India, once cancelled cannot be re-booked.
FOREX FACILITIES FOR RESIDENTS (INDIVIDUALS)
Liberalized Remittance Scheme of USD 25,000:
• This is a new facility extended to all resident individuals’ tinder which they may freely remit up to USD 25,000 per calendar year for any permissible current or capital account transaction or a combination of both.
• The facility is available to resident individuals only.
• The remittances can be in any currency equivalent to. USD 25,000 in a calendar year.
• Resident individuals can avail of the remittance facility under the scheme once in a calendar year.
• Individuals are free to use this scheme to acquire and hold immovable property, shares or any other asset outside India without prior approval of RBI.
• Individuals are free to open, hold and maintain foreign currency accounts with a bank outside India to make remittances under the scheme without the prior approval of RBI.
• The investor is free to book profit or loss abroad and to invest abroad again. The investor is under no obligation to repatriate the funds sent abroad.
• Once a remittance is made for an amount up to USD 25,000 during the calendar year, the investor cannot make any further remittances under this route, even if the proceeds of the investments have been brought back into the country.
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References for further reading
1. Foreign exchange – an introduction to the core concepts- Mark Mobius – master class
2. Rajwade, A. V., Foreign exchange international finance and risk management.
3. Bhardwaj, H. P., Foreign exchange Handbook
4. Thakurta, P. P., foreign exchange and money market operations terms and concepts
5. Dun & Bradstreet, Foreign exchange markets
6. Reserve bank of India Guidelines for internal control for foreign exchange business, Master circulars, Circulars issued from time to time (www.rbi.org.in)
7. FEMA 1999
8. FEDAI rule book and various circulars on the subject.
9. FEDAI study booklets for orientation workshops
10. Gardner, D. C., Financial distance learning workbooks
11. Beedu, R. R., Foreign exchange risk management
12. Bose, Rupnarayan, Fundamentals of International Banking
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