Guide to International Banking – Foreign Exchange & Role of RBI

Table of Contents

1. International Banking In India

2. Dynamics of Foreign Exchange Market

3. Foreign Exchange Market and RBI

4. Forex Market Players in India

5. Foreign Exchange Segments

6. Foreign Exchange Correspondent Banking Relations

7. Banks as Market Makers

8. Interbank Forex Quote

9. Two Way Quote

10. Other Rates Used In International Markets

11. Bank as Forex Dealer

12. Foreign Exchange Products

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After reading this blog, you will be able to understand the following:

To understand intricacies of foreign exchange market. To understand the motives of foreign exchange transactions by different players in the economy. To understand the role of RBI about the categories of players in foreign exchange market. To understand the functions of international banking division of the bank. To understand role of FEDAI and FEMA in foreign exchange market. To understand foreign exchange quote and role of banks as market makers. To understand foreign exchange risk exposure and hedging tools in foreign exchange market transactions. Treasury and Foreign Exchange Management in banks.

1. International Banking In India

The international banking services in Indian banks are to the benefit of Indian customers, Corporates, NRIs, foreign companies/individuals through the Authorized dealers and integrated treasury operations. The banks provide facilities and products as per guidelines of Reserve Bank of India. NRI banking, foreign currency loans, facilities to importers and exporters, remittances (inward and outward), forward sales and purchase contracts booking, cross currency, interest rate swap, Forex money market operations are some of the major products and services offered by authorized foreign exchange branches of the bank. Correspondent banking relationship and swift transfers coupled with technology transfers aid authenticity to the messages. All the banks have delegated authority from the regulator (RBI) to perform Forex transactions (sales and purchases) through Forex license. Foreign currency is like a commodity that is purchased and sold by a bank. When bank purchases foreign currency the bank acquires a foreign currency and parts with home currency and when bank sales; the bank parts with foreign currency and acquires home currency. RBI does a post-facto scrutiny on the delegated powers through structured MIS- statements and returns on a periodical basis and with the data country’s Balance of Payment is prepared.

2. Dynamics of Foreign Exchange Market

The foreign exchange market is the market where the currency of one country is exchanged for that of another country and where the rate of exchange is determined.

The genesis of foreign exchange market can be traced to the need for foreign currencies arising from:

• • International trade
  • Foreign investment
  • Lending to and borrowing from foreigners

Foreign exchange is the settlement and arrangement of funds around the world, by buying and selling currencies. More than us$ 5.3 trillion are exchanged daily by thousands of banks and foreign currency traders all over the world.

The United Kingdom is the world’s foremost trading centre with a 41 per cent share followed by the United States at 19 per cent. Singapore overtook Japan to become the world’s third major trading centre. The US dollar is the most dominant currency, while the euro saw its share of total trade drop to the lowest since the currency’s inception in 1999, reflecting the impact of the euro zone sovereign debt crisis which began in 2010. It is a worldwide, decentralized over-the-counter (OTC) financial market for the trading of currencies and financial centres around the world. It functions as anchors of trading between a wide range of different types of buyers and sellers – 24 hours a day (excluding weekends). About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end. In the Forex market, the proportion of transactions that are directly related to international trade activities is relatively low. Most of the transactions are actually speculative trading which cause currency movement and influence exchange rates. When the market predicts that a certain currency will rise in value, it may spark a buying instantly that pushes the currency up and fulfil the prediction. Conversely, if the market expects a drop in value of a certain currency, people will start selling it away and the currency will depreciate.

Fluctuations in foreign exchange may occur due to inflation rate and interest rate differentials; change in macro economic conditions of the country (change in monetary and fiscal policy of the government). Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates. Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The opposite relationship exists for decreasing interest rates – that is, lower interest rates tend to decrease exchange rates. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. It can be summarised as:

• • If inflation increases Interest Rate would Increase Domestic Currency value should depreciate
  • If inflation decreases Interest Rate would decrease Domestic Currency value should appreciate

Most active Forex markets in order are:

• • UK (London),
  • USA,
  • Japan,
  • Singapore,
  • Switzerland,
  • Hongkong,
  • Germany, France and Australia

All other markets combined together, represent only 15% of the total volume, traded globally.

3. Foreign Exchange Market and RBI

Under the Foreign Exchange Regulation Act (FERA), 1947, a few foreign banks, designated as Exchange Banks were permitted to transact foreign exchange business. The terms and conditions for undertaking such business were being laid down by the then Exchange Banks’ Association. With the increase in India’s foreign trade, several scheduled commercial banks were authorized by the Reserve Bank to deal in foreign exchange business. This led to the formation of Foreign Exchange Dealers Association of India (FEDAI) on August 16, 1958 with a mandate to lay down the terms and conditions which were mandatory in nature for the Authorized Dealers (ADs – commercial banks). The prime functions of FEDAI are:

• • To frame rules for the conduct of foreign exchange business in India. The rules cover various aspects like hours of business, charges for foreign exchange transactions, inter-bank dealings etc. Authorized dealers have given an undertaking to the RBI to abide by the FEDAI guidelines.
  • To coordinate with RBI in proper administration of foreign exchange
  • To circulate information amongst its members that is likely to be of interest to them.
  • FEDAI acts as a mouthpiece of the authorized dealers (ADs) and represents their views to the RBI and other international agencies.

3.1 Milestones in India’s Foreign Exchange Market

In the year 1994, an Expert Group on Foreign Exchange Market in India was set up under the Chairmanship  of Shri. O. P. Sodhani, the then Executive Director, Reserve Bank of India (popularly known as the Sodhani Committee). FEDAI played an important role in supporting the Reserve Bank in implementing significant measures and suggestions aimed at major reforms in the market. The second milestone was the replacement of restrictive FERA with the Foreign Exchange Management Act (FEMA) in the year 2000.

Following the recommendations in June 2000 a legal framework, implementation of FEMA, has been put into effect to ensure convertibility on the current account. As emphasized by the Rangarajan Committee that there could be capital outflows from residents in the reflection of current account transactions after current account convertibility, certain safeguards were also built into the system after FEMA came into effect. For example:

• • First, the requirement of repatriation and surrender of export proceeds was continued, with provision of Exchange Earners Foreign Currency (EEFC) account for use by exchange earners.
  • Second, all authorized dealers were allowed to sell foreign exchange for underlying current account transactions supported by documentary evidence.
  • Third, a proactive approach in the development of money, government securities and forex markets has been adopted.
  • Fourth, effort has been made to improve the information base on transactions in the forex markets with respect to its nature and magnitude through reports and statements. The insistence on adequate and timely reporting requirements from authorized dealers for various foreign exchange transactions also helped in simplification and liberalization process.
  • Fifth, as a general rule, genuine hedging of exposures under specified conditions is allowed.

This consistent approach has lent credibility to the liberalization process of both current and capital account transactions.

FEMA provided a de jure status to the shift in the policies with regard to the external sector reforms that began in 1990-91. Further and more importantly, FEMA has diluted the rigorous enforcement provisions which were the hallmark of the erstwhile legislation.

3.2 FEMA and Sections Covered

The Foreign Exchange Management Act, 1999 (FEMA) came into force with effect from June 1, 2000. With the introduction of the new Act in place of FERA, certain structural changes were brought in. The Act consolidates and amends the law relating to foreign exchange to facilitate external trade and payments, and to promote the orderly development and maintenance of foreign exchange in India.

From the NRI perspective, FEMA broadly covers all matters related to foreign exchange, investment avenues for NRIs such as immovable property, bank deposits, government bonds, investment in shares, units and other securities, and foreign direct investment in India.

FEMA vests with the Reserve Bank of India, the sole authority to grant general or special permission for all foreign exchange related activities mentioned above.

Section 2 provides clarity on several definitions and terms used in the context of foreign exchange. Starting with the identification of the Non-resident Indian and Persons of Indian origin, it defines “foreign exchange” and “foreign security” in section 2(n) and 2(o) respectively of the Act. It describes at length the foreign exchange facilities and where one can buy foreign exchange in India. FEMA defines an authorized dealer, and addresses the permissible exchange allowed for a business trip, for studies and medical treatment abroad, forex for foreign travel, the use of an international credit card, and remittance facility.

Section 3 prohibits dealings in foreign exchange except through an authorized person. Similarly, without the prior approval of the RBI, no person can make any payment to any person resident outside India in any manner other than that prescribed by it. The Act restricts non-authorized persons from entering into any financial transaction in India as consideration for or in association with acquisition or creation or transfer of a right to acquire any asset outside India.

Section 4 restrains any person resident in India from acquiring, holding, owning, possessing or transferring any foreign exchange, foreign security or any immovable property situated outside India except as specifically provided in the Act.

Section 6 deals with capital account transactions. This section allows a person to draw or sell foreign exchange from or to an authorized person for a capital account transaction. RBI in consultation with the Central Government has issued various regulations on capital account transactions in terms of sub-sections (2) and (3) of section 6.

Section 7 covers the export of goods and services. All exporters are required to furnish to the RBI or any other authority, a declaration regarding full export value.

Section 8 puts the responsibility of repatriation on the person’s resident in India who has any amount of foreign exchange due or accrued in their favour to get the same realized and repatriated to India within the specific period and in the manner specified by the RBI.

The duties and liabilities of the Authorized Dealers have been dealt with in Sections 10, 11 and 12, while Sections 13 to 15 cover penalties and enforcement of the orders of the Adjudicating Authority as well as the power to compound contraventions under the Act.

Sections 36 and 37 deal with the establishment of an Enforcement Directorate, and empowers it to investigate the violation of any provisions of the Act, rules, regulations, notifications, directions or order issued under this Act.

3.3 Difference between FERA and FEMA

FEMA, which has replaced FERA, had become the need of the hour since FERA had become incompatible with the pro-liberalization policies of the Government of India. FEMA has brought a new management regime of Foreign Exchange consistent with the emerging frame work of the World Trade Organization (WTO). Enactment of FEMA also brought with it Prevention of Money Laundering Act, 2002 which came into effect from 1 July, 2005. Following are the points which distinguish FERA from FEMA:

• • Unlike in FERA, the prosecution has to prove the guilt of the accused person. Further, under FEMA only monetary penalty are provided for contraventions.
  • The categorization of offences under FEMA as civil and not criminal constitutes one of the most important differences between the two statutes. Contravention of FEMA provisions are dealt with under civil law procedures, for which separate administrative procedure and mechanism in the form of Compounding Rules, Adjudicating Authority, Special Director (Appeals) and Appellate Tribunal have been established.
  • Another significant change has been that for each process of law a time-frame has been provided in the Act. For example, the process of compounding is required to be completed within 180 days.
  • The concept of compounding in FEMA is another distinguishing feature, especially from the perspective of customers.
  • Under FERA, all violations were subject to separate investigation and adjudication of the Directorate of Enforcement. However, FEMA provides for an opportunity of seeking compounding of contraventions, in terms of which a contravener has a suo motu opportunity of making an application to the compounding authority seeking the contravention to be compounded.
  • The compounding authority is required under the Act to dispose of the application within 180 days and further the Reserve Bank is in the process of issuing the necessary direction for implementation of the process for compounding of contravention under FEMA. I am sure the new procedure will go a long way in providing a quick and hassle-free disposal of cases involving contravention(s) of FEMA.
  • The Government of India has, therefore, in consultation with Reserve Bank placed the responsibilities of administering compounding of cases with the Reserve Bank, except under section 3(a) of FEMA. Directorate of Enforcement would continue to exercise powers of compounding under clause (a) of section 3 of FEMA (dealing essentially with Hawala transactions).
  • The emphasis of the Reserve Bank has been to ensure that procedural formalities are minimized so that exporters and others are able to concentrate on their core activity rather than engaging in avoidable paper work, while ensuring observance of Know-Your-Customer (KYC) guidelines in not so required cases.
  • A number of initiatives have been taken towards procedural simplification with an objective of reducing the transaction cost. In the case of individuals, foreign exchange for current account transactions such as education, medical, travel, emigration, maintenance of close relatives abroad can be drawn from the Authorized dealer based on simple declaration up to certain indicated limits.
  • The system of self write off and self extension of due date for export realization for exporters was introduced followed by raising the threshold limit for GR declaration.
  • Similarly, the simplifications of procedures for import remittances have also been introduced. Overall, measures for simplification of procedures have been made subject to KYC and Anti Money Laundering guidelines.
  • In recent years, the Reserve Bank has delegated authorities to authorized dealers to such an extent that there is hardly any need for the individuals to approach the Reserve Bank for any approval.

4. Forex Market Players in India

Foreign exchange market in India is totally structured, well regulated both by RBI and also by a voluntary association (Foreign Exchange Dealers Association). Only Dealers authorized by RBI can undertake such transactions. Foreign exchange can be purchased from any authorized person, such as:

• • Authorized Dealer (AD) Category-I banks and AD Category-II dealers. The Authorized Dealers have to get License of Foreign Exchange from RBI Branches and can function under following categories:
    Category A – Position Maintaining Offices – IBDs (International Banking Division)
    Category B – Authorized Branches having license from Category A
    Category C Branches – Unauthorized Branches
  • Full-Fledged Money Changers (FFMCs) are also permitted to release exchange for business and private visits.
  • Authorized Money Changers (AMCs) are entities, authorized by the Reserve Bank under section 10 of the Foreign Exchange Management Act, 1999. An AMC is a Full Fledged Money Changer (FFMC) authorized by the Reserve Bank to deal in foreign exchange for specified purposes.
  • All inter-bank dealings in the same centre must be affected through accredited brokers, who are the second arm in the market-structure. However, dealings between the authorised dealers and the RBI and also between the AD (Authorised Dealers) and overseas Banks are affected directly without the intervention of the brokers.
  • In addition to the authorized dealers covering commercial banks, who undertake comprehensive transactions covering all spheres of foreign exchange, there are also a peripheral market consisting of licensed money changers and travel agents, who enjoy limited authorization especially for encashment of traveller’s cheques, notes. Money Changers have to get license from RBI to deal in sale/purchase of currencies and Traveller Cheques. Thomas Cook , LKP Forex, Weizmann Forex Services etc. Can be Full fledged Money Changers (FFMC who can sale/Purchase all Currencies or Restricted Money Changers (RMC)
  • Specified hotels and Government owned Shops are also given restricted licenses to accept payment from non-residents in foreign currencies.
  • IDBI and EXIM Bank are permitted to handle and hold foreign currencies in a restricted way.

5. Foreign Exchange Segments

The foreign exchange market can be classified into two segments. The merchant segment consists of the transactions put through by customers to meet their transaction needs of acquiring/offloading foreign exchange, and inter-bank segment encompassing transactions between banks. The banks deal among themselves directly or through foreign exchange brokers. The inter-bank segment of the Forex market is dominated by few large Indian banks with State Bank of India (SBI) accounting for a large portion of turnover, and a few foreign banks with benefit of significant international experience

5.1 International Banking Division

International banking division of the bank may deal directly or through recognised exchange brokers as per RBI norms and adhering to FEDAI rules and regulations in following category of operations in foreign exchange market:

• • Calculation of Exchange Rates (Card Rates) and Its Circulation to Authorized Branches.
  • To Maintain Position and to Undertake Cover Operations.
  • To Maintain Nostro Accounts in Foreign Currencies with Foreign Banks.
  • To Issue General Guidelines to Authorized Branches and be a link between RBI and these Branches.
  • Management of Foreign Currency Assets and Liabilities for the Bank.

6. Foreign Exchange Correspondent Banking Relations

Foreign Exchange branch of a Bank has agency arrangements with various Foreign Banks On reciprocal Bases in the following categories:

• • NOSTRO ACCOUNT: An account maintained by an Indian bank with a bank abroad in foreign currency. “Our Account with You”. For example: Punjab National Bank having an account with American Express Bank in USD.
  • VOSTRO ACCOUNT: An account opened by a foreign bank with an Indian bank in rupees. “ Your Account with Us”. For example: American Express Bank having an account with Punjab National Bank in INR.
  • LORO ACCOUNT: For example Oriental Bank is having an account with Chase. When Bank of Baroda refers to this a/c while corresponding with Chase, it would be referred as LORO a/c. “Their a/c with you”

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7. Banks as Market Makers

When a bank buys foreign exchange from the customer, it sells the same in the interbank market at a better rate and tries to make a profit out of the transaction. In this way, the interbank buying rate forms the basis for quotation of buying rate by the bank to its customer. Likewise, when the bank sells foreign exchange to the customer, it purchases the required foreign exchange from the interbank market. Therefore, the interbank selling rate forms the basis for quotation of selling rate to the customer. The market Quote for a currency consists of the spot and the forward margin. The outright forward rate has to be calculated by loading the forward margin into the spot rate. When the forward margin for the month is given in ascending order, it indicates forward currency is at premium. The forward outright rates are arrived at by adding the forward margin to the spot. The exchange rate quoted for currency by different market makers may differ slightly. But the difference in the rates quoted by market makers will not differ to the extent required to enable arbitraging.

Illustration: Suppose the spot rate quoted in the market by different banks are as follows:

PNB Bank Spot USD Spot: INR 62.6250/6375

Canara Bank Spot USD Spot: INR 62.6175/6300

HDFC Bank USD Spot: INR 62.6200/6325

It is evident that if one buys USD from PNB @ 62.6375 INR and sells to Canara 2.6175 INR then he/she will incur loss. Also, if one buys from HDFC @62.6325 and sells to PNB @ 62.6250 then he/she will incur loss. So in any case the customer cannot indulge in arbitraging gain by buying USD from one bank and selling it to the other bank.

8. Interbank Forex Quote

There are two common ways to quote exchange rates,

Direct Quotation: Exchange rate is expressed as price per unit of Foreign Currency in terms of home currency. This is also known as price quotation. Number of units of Foreign Currency is constant and any change in the exchange rate will be made by changing the value in terms of rupees. Maxim: Buy Low Sell High

The exchange rate of the domestic currency is expressed as equivalent to a certain number of units of a foreign currency. It is usually expressed as the amount of domestic currency that can be exchanged for 1 unit or 100 units of a foreign currency (1 USD = 62.5420 INR). The more valuable the domestic currency, the smaller the amount of domestic currency needed to exchange for a foreign currency unit and this gives a lower exchange rate (1 USD = 60.2420 INR). When the domestic currency becomes less valuable, a greater amount is needed to exchange for a foreign currency unit and the exchange rate becomes higher (1USD = 64.4240). In other words, the variation of the exchange rates is inversely related to the changes in the value of the domestic currency. When the value of the domestic currency rises, the exchange rates fall; and when the value of the domestic currency falls, the exchange rates rise. Most countries use direct quotation. Most of the exchange rates in the market such as USD/JPY, USD/HKD, USD/INR and USD/RMD are also quoted using direct quotation.

Indirect Quotation: It is the commodity of the trade-in foreign currency which is varying in accordance with the change in the exchange rates. This is also known as the quantity quotation. For a fixed unit of home currency the bank would acquire more units of foreign currency while buying and part with lesser units of foreign currency while selling.

8.1 Maxim: Buy High Sell Low

The exchange rate of a foreign currency is expressed as equivalent to a certain number of units of the domestic currency. This is usually expressed as the amount of foreign currency needed to exchange for 1 unit or 100 units of domestic currency. The more valuable the domestic currency, the greater the amount of foreign currency it can exchange for and the lower the exchange rate. When the domestic currency becomes less valuable, it can exchange for a smaller amount of foreign currency and the exchange rate drops.

Under indirect quotation, the rise and fall of exchange rates are directly related to the changes in value of the domestic currency. When the value of the domestic currency rises, the exchange rates also rise; and when the value of the domestic currency falls, the exchange rates fall as well. Most Commonwealth countries such as the United Kingdom, Australia and New Zealand use indirect quotation. Exchange rates such as GBP/USD and AUD/USD are quoted indirectly.

Based on the market practice, foreign exchange rates quotation normally consists of five significant figures. Starting from right to left, the first digit is known as the “pip”. This is the smallest unit of movement in the exchange rate. The second digit is known as “10 pips”, so on and so forth.

For Example 1 USD = 1.15300 AUD (direct quote), 1 AUD = 0.86730 USD (indirect quote)

If AUD/USD changes from 1 AUD = 0.86730 USD to 1 AUD = 0.86735 USD, we say that the AUD/USD has risen by 5 pips.

9. Two Way Quote

For most currencies, dealers in foreign exchange market offer two way quotes (to buy and to sell foreign currency), results in liquidity and transparency in foreign exchange market. The lower the difference between Ask and Bid (difference between selling and buying foreign currency per unit of domestic currency is known as Spread) greater is the liquidity in currency market.

9.1 BID and ASK Rate

In the inter-bank market, SBI along with other banks may be considered as the market-makers, i.e., banks which are always ready to quote two-way quotes both in the spot and swap (swap one currency with other) segments. The market makers are expected to make a good price with narrow spreads both in the spot and the swap segments. The efficiency and liquidity of a market are often gauged in terms of Ask –Bid spreads. Wide spreads are an indication of an illiquid market or a one way market or a nervous condition in the market. In India, the normal spot market quote has a spread of 0.5 to one paisa. At times of volatility, the spread widens to 5 to 10 paise.

BID is buying rate of foreign currency in lieu of domestic currency by the bank and Ask is selling rate of foreign currency in lieu of domestic currency by the bank. The difference between Ask and Bid is spread.

Direct and Indirect Two Way Quotes

Direct	Quote	Indirect	Quote
USD/JPY	109.7644/26	EUR/USD	1.2500/01
USD/HKD	7.7607/45	GBP/USD	1.6000/02
USD/CHF	0.9720/32	AUD/GBP	0.8674/05

Illustration: USD/JPY 109.7644 = Buying Rate of USD (bank will buy 1 USD from the customer and will pay him/her 109.7644 JPY per USD). This is known as BID Rate as bank is buying foreign currency and foregoing domestic currency.

USD/JPY 109.7644 + .0026 = 109.7670 Selling Rate of USD (bank will sell 1 USD by charging 109.7670 JPY from the customer). This is known ASK rate as bank is selling foreign currency and receiving domestic currency.

Difference between ASK Rate and BID Rate is known as spread (USD/JPY Spot; 109.7670-109.7644 = .0026)

9.2 Cross Rate

All transaction in international banking are settled in USD hence any transaction in currency other than USD and INR will result in Cross rates quotation for the Forex branch of the bank.

Illustration: The market quotes for Cross Rates are as follows:

1. GBP/USD = 1.5700 GBP is base currency

USD/CHF = 0.9300 USD is base currency

Find GBP/CHF

Solution :

GBP/USD × USD/CHF = 1.5700 × 0.9300 = 1.4601 = GBP/CHF

2. EUR/USD 1.4500.

GBP/USD 1.7500

Find EUR/GBP

Solution:

1. a. Find 1/bid price for GBPUSD = 1/1.7500 = 0.5714
2. b. multiply the EUR/USD bid price by the bid price USD/GBP
3. c. EUR/GBP: 1.4500 × 5714 = 0.8286

Basic Formula: Currency A/Currency B = (Currency A/USD) × (USD/Currency B)

Cross rates for JPY/INR, GBP/INR and GBP/JPY are as follows:

Solution (Calculation manual)

1. JPY/INR: 0.4140/0.4146
2. GBP/INR 81.82/81.90
3. GBP/JPY 197.45/197.74

10. Other Rates Used In International Markets

(i) LIBOR – London Interbank Offered Rate/MIBOR (Mumbai Interbank Offered Rate/SIBOR – Singapore Interbank Offered Rate/EURIBOR – Euro Interbank Offered rate

(ii) LIBID – London Interbank Bid rate/MIBID/SIBID/EURIBID

(iii) LIMEAN – London Interbank Mean Rate { (LIBOR + LIBID)÷ 2} , MIMEAN, SIMEAN, EURIMEAN

(iv) Tom Rate: Tomorrow’s rate

(v) CABLE: Pegging between USD and GBP

11. Bank as Forex Dealer

Foreign exchange transactions are through Bank’s dealing rooms. It offers a two way quote to purchase and sale foreign currency. One dealing room of the bank has almost 100 dealers, operating from the same room dealing in different currencies, markets and products. It connects with foreign exchange branch of the bank and branch deals with exporters, importers, investors, hedgers and individuals.

Bank’s Forex risk exposure can be in following ways:

• • Intra-day open position in each currency
  • Overnight open position in each currency, should be less than intra-day open position.
  • Aggregate open position for all currencies
  • Turnover on daily transaction volume for all currencies
  • Country wise exposure of the bank’s customer and bank’s investments.

Bank covers every large purchase with matching sale in USD so that FOREX risk exposure of the bank can be minimized. Bank’s squares off the net short position (dealer has sold more dollar than it has bought) by buying foreign currency and net long position (dealer has bought more USD than it has sold) by selling foreign currency respectively at spot rate.

11.1 Bank’s USD Positioning as a Forex Dealer

Illustration

A Forex dealer has the following dealing position in Frankfurt. What he must do to make it square?

His account in Frankfurt is overdrawn Euro 3,75,000. He has purchased Cheques, which are in course of post and not yet credited to his account totalling EUR 3,28,000. He has forward contracts outstanding as follows:

Sales EUR 1,63,86,000

Purchases EUR 1,46,06,250

He has issued drafts not yet presented for payment for EUR 12,20,080. He has long bills purchased in hand and not due for EUR 28,85,640

Solution

	PURCHASES	SALES
Balance (Overdrawn)		3,75,000
Cheques Purchased	3,28,000
Sales		1,63,86,000
Purchases	1,46,06,250
DD Issued		12,20,080
Bills Purchased	28,85,640
	1,78,19,890	1,79,81,080
	1,61,190
	1,79,81,080

The Bank has oversold position by EUR 1, 61,190. He has to buy this amount to make it square to nearest amount –EUR 1, 60,000 . This can be done by Interbank deals, Arbitrages, derivatives and other tools available to the Dealer . EUR 190 will go to pipeline funds and can be added to opening balance of the next day.

Illustration:  On 8th of September 2014, an exporter tenders a demand bill for USD 1,00,000  drawn on New York ruling rates for USD in the interbank market are as under:

Spot ————————USD1	= ` 59.3000/3500
Spot/September	6000/7000
October	8000/9000
November	1,0000/1000

Transit period is 20 days. You require an exchange margin of 0.15%. Interest on export finance is 8% p.a.

The Customer opts to retain 15% of proceeds in US   Dollars  in EEFC  account

To know :

(a) The rate at which the Bank will purchase the bill.

(b) The rupee amount payable to the customer

(c) Interest to be recovered from the Customer

Solution

Currency is at Premium, transit Period will be rounded off to lower month NIL i.e. SPOT  BILL IS DEMAND SIGHT

BUY Transaction —59.3000X (-) 0.15% = 0.0889

59.3000-0.0889=   59.2111    Round Off =59.2100 INR

Customers account will be credited with USD 85000 i.e. 85 % of the Bill

Amount Credited –85000 × 59.2100 =  50,32,850 INR   

Interest charged for 20 days at 8 % = 50,32,850  ×  20  ×  8/36500=  22061.80 INR

Total Amount Payable to the customer 50,32,850-22061.80 = 50,10,788.20 INR

Amount  to be credited in EEFC account  is  USD  15000

Illustration   M/s Rex Exports offers to HSBC New Delhi a sight bill for USD 258000 on 01.01.14  drawn under a letter of Credit established by Amas Bank Geneva. Assuming the following please tell how much INR will you credit to the exporters account?

Inter -bank rate —1USD =62.5850/60 INR

Transit period is 10 days

Interest rate is 11%

Exchange margin is 0.15%

Solution:

Bills Buying Rate = 62.5850 × .15 %(-) = .0939  Thus  62.5850  -0.0939=62.4911

Rounded off to = INR 62.4900

Amount Credited 62.4900 × 258000 = INR 1612242     

Interest Charged   INR 1612242 × 11 × 10/36500 = INR 4858.80

Total Amount Credited = Amount Credited – Interest = 1612242- 4858.80 = INR 16,07,383.20

Illustration   On 01.04.14 the ruling rates are

Inter Bank 1USD = ` 60.5850/5950

The bank has been authorized to retain 0.090% for the transaction involving Inward remittance of USD 91758 value spot. In the rupee terms how much will the customer get and what is the effective exchange rate?

Solution:

The  Bank  has Buying transaction as Inward remittance is there .So Buying rate 60.5850 will be applied

60.5850X 0.090% = 0.0545 60.5850-0.0545= INR 60.5305

Rounded off   = 60.5300 X 91758 = INR 5554111 .74  à 55,54,112 INR

Ans: The customer will get   55,54,112 INR

12. Foreign Exchange Products

12.1 Spot Transactions

Currencies are mostly bought and sold in Spot transactions. Spot transactions of payment and receipt of funds in respective currencies takes place in two working days from the trade date . Today + Tomorrow and Day after Tomorrow is the validity but if settled by cash settlement it will be Today (i.e. if a customer wants to sell USD on 15th Jan. 2015 than the settlement will be done of buying of USD by the bank and making payment in INR to the customer by 16th Jan. 2015).Currency can also be bought and sold same day with settlement on the same day (i.e. on 15th Jan. 2015 in above case) or, on the next day (i.e. 16th Jan. 2015). All the exchange rates quoted on the official site are Spot Rate unless otherwise specified.

Spot is the simplest transaction used by corporate to cover their receivables and payables. It is a commitment by a client to buy or sell one currency against another at a fixed rate or delivery two business days after the transaction. Similarly the buyer of exchange will receive the foreign exchange he/she has bought immediately.

12.2 Forward Transactions

There is another important market, the Forward Market. In a forward market when the bargain is settled, the seller agrees to sell at a certain amount of foreign exchange to be delivered at a future date at a price agreed upon in advance. Analogously a buyer agrees to buy certain amount of foreign exchange at a future date at a predetermined price. Commonly used forward contracts are for duration of one month(30 days) 3 months (ninety days), six months (180 days), nine months (270 days) and one year (360 days).

Forward exchange rates are arrived at on the basis of interest rate differentials of two currencies, added or deducted from spot exchange rate.

F= S e^rt

F= Forward rate, S= Spot Rate, r=Rate of Interest, t = Time period of Forward, e=exponential =2.71829

The market Quote for a currency consists of the spot and the forward margin. The outright forward rate has to be calculated by loading the forward margin into the spot rate. Forward margin is the difference between forward and spot rate. If forward margin is at premium that signifies foreign currency will appreciate and domestic currency will depreciate in future Example. On 15th Jan 2015, 1USD = 60.2430/34 INR and on 15th March 2015 1 USD = 61. 2430/38 INR. When the forward margin for the month is given in ascending order, it indicates forward currency is at premium. The forward outright rates are arrived at by adding the forward margin to the spot. Forward margin is expressed in 0.0001 of the currency.

• • Forward Rate = Spot Rate – (At Par)
  • Forward Rate – Spot Rate = Forward Margin

Illustration: Spot Oct USD/INR 60.2043/2048

Spot/Nov USD/INR 3020/3080

Spot/Dec USD/INR 2040/2020

Note: Forward Outright rate for Nov will be: Since forward margin is at premium hence we will add forward margin to Bid and Ask spot rate respectively.

3. USD/INR 60.2043 + .3020 = 60.5063 Bid Rate
4. USD/INR 60.2048 + .3080 = 60.5128 Ask Rate

Hence Forward outright rate for Nov USD/INR 60.5063/5128

Note: Forward Outright rate for Dec: Since forward margin is at discount hence we will deduct forward margin from bid and ask rate respectively.

Forward Outright rate for Dec USD/INR (60.2043- 0.2040)/(60.2048-0.2020)

Ans: Hence Forward outright rate for Dec USD/INR 60.0003/0028