FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE MARKET

FOREX market: foreign currencies are bought and sold

Ex: If an Indian importer imports goods from USA and has to make payments in US dollars

rganizational setting : individuals, governments and O

banks A quantity of one currency by paying a quantity of another currency Helps international trade and investment Helps business convert one currency to another Formed during the 1970s

DEFINITION OF FOREIGN EXCHANGE

As per FEMA (1999): Foreign exchange refers to;

Deposits, credits and balances payable in foreign currency Drafts, travellers cheques, letter of credit or bill of exchange

expressed or drawn in Indian currency but payable in foreign currency rafts, travellers cheques, L/Cs, etc. drawn by banks, D institutions or persons outside India but payable in Indian currency

TIME ZONES
The foreign exchange market is round-the-clock market due to different time zones

Unique
Its trading volumes

The extreme liquidity of the market

Its geographical dispersion Long trading hours - 24hours a day The low margins large volume

Trading Characteristics
Over the counter market (OTC) No single unified foreign exchange market Interconnected marketplaces The main trading centers London New York Tokyo Hong Kong Singapore

Trading Characteristics
No Insider information Actual monetary flows, changes in GDP growth, Inflation,

interest rates, budget and trade deficits or surpluses and other macro-economic conditions : effect forex Major news is released publicly often on scheduled dates

Major Players
Travellers Tourists

Retail Market

Wholesale Market/Inter Bank Market

Commercial banks Forex brokers Central bank MNCs, Individuals, SMEs

Retail Market

The travellers and tourists exchange one currency for

another in the form of currency notes or travellers cheques

WHOLESALE MARKET
COMMERCIAL BANKS Behalf of clients Retail level : through inter bank market or through specialized brokers Bulk level : through inter-bank wholesale market or international banks and brokers FOREX BROKERS Agents : facilitate trading between dealers

WHOLESALE MARKET
CENTRAL BANKS Maintaining the exchange rate at desired level MNCs MNCs are participating in forward exchange market INDIVIDUAL Investment and commercial activities

Regulatory Structure
FEMA, 1999 regulates the foreign exchange market in India Before this Act, The Forex market in India was regulated by

the RBI through the Exchange Control Department, by the FERA, 1947 After independence, FERA was introduced as a temporary measure to regulate the inflow of the foreign capital The Economic and Industrial development led to the urgent need of foreign currency On the recommendation of the Public Accounts Committee, GOI passed the Foreign Exchange Regulation Act,1973 and gradually this act became famous as FEMA

Contd..
RBI has issued Authorised Dealers (AD) licenses to banks,

all India financial institutions and a few co-operative banks to undertake foreign exchange transactions in India It has also issued Money Changer licenses to a large number of established firms, companies, hotels, shops, etc. Money changers help facilitate encashment of foreign currencies of foreign tourists Entities authorized to buy and sell foreign currency notes, coins and travellers cheques are called Full Fledged money changers Those authorized only to buy are called Restricted money changers

Category of license (Number) Authorized Dealers (87)

Entities Commercial Banks - 84; State Co-operative Bank 1; Urban Co-operative Bank 2 Financial Institutions 4 (EXIM, IFCI, SIDBI ,CCIL) Factoring Agencies 5 Department of Post Urban Cooperative Bank 9 Other FFMCs 869 Thomas Cook India Ltd.

Major Activities All permissible current and capital account transactions

Financial Institutions (9)

Activities related to financing of international trade undertaken by these institutions Sale/Purchase of foreign exchange for private and business visits abroad

Full Fledged Money Changers (879)

Others (1)

Specified non trade related current account transactions

Structure of the FOREX

Forex market in India consists of three tier system The first consists of transactions between RBI and the

Authorized Dealers(ADs) Second tier is the inter bank market in which the ADs deal with each other Third tier consists of transactions between ADs and their corporate customers The daily turnover in the Indian foreign exchange market is currently estimated to be between USD 1.5 3 billion

FEDAI
FEDAI (Foreign Exchange Dealers Association of India) is

a non-profit making body formed in 1958 with the approval of RBI Its members are authorized dealers Prescribes guidelines and rules of the game for market operations, merchant rates, quotations, delivery dates, holidays, interest on defaults, etc. FEDAI also advises RBI on market related issues and supplements RBI on strengthening the market

INDIAN FOREX MARKET

EXCHANGE RATE

he price of one currency viewed in relation to another T

currency XAMPLEE Re/$ 44.76 means 44.76=1USD

FACTORS AFFECTING FOREIGN EXCHANGE

Fundamental reasons
Technical reasons Speculation

FUNDAMENTAL REASONS

Balance of payments-> surplus-> appreciation Growth rate of the economy-> higher growth->depreciation

of currency Fiscal policy-> financing of fiscal deficit influences exchange rate Monetary policy->loose monetary policy->depreciation of exchange rate

TECHNICAL REASONS

Freedom or restrictions on capital movements can affect

exchange rates to a large extent Among other factors there are: Huge trade surpluses of oil exporting countries Capital moving from low-yielding currencies to high yielding currencies(interest differential)

SPECULATION

Self-fulfilling prophecies

Anticipation of depreciation of a currency can cause dealers to sell that currency Speculation serves to provide depth and liquidity to the forex market

DIRECT QUOTE X units Of Domestic Currency equal One Unit Of Foreign currency xampleE Rs 44.20 Per USD Is a Direct Quote For USDIn India INDIRECT QUOTE he domestic currency is the commodity which is being T bought and sold. Commodity comes first and price next XAMPLEE Re1= .02 USD

BID AND ASK

Banks Quote Of Bid And Ask Is From The Bankers The

Perspective. Bid= Buy Ask=sell I F THE BID RATE FOR USD IS 40 IT MEANS THAT THE BANK IS READY TO BUY 1$ FOR Rs.40 I F THE ASK RATE IS FOR USD IS 41, IT MEANS THAT THE BANK IS (ASKING IF SOMEONE WILL BUY) SELLING 1$ FOR Rs.41

Intervention Currency
The Foreign currency in which rates are quoted against the domestic currency. In India the intervention currency is USD

Two way quote

ID QUOTE AND ASK QUOTE B x: Re/$-40.42 41.63 E s.40.42-bid(buying)-( Bank point of view) R s.41.63-ask(selling) R s.40.42=1$ means the quote is in India R en33= Re.1 means the quote is in Japan Y f you want to buy, if you have $, you will getRs.40.42 I If you want to sell Rs. and buy $ you part withRs.41.63

Spread
ASK MINUS BID=SPREAD X. 40-41 E SPREAD=Rs.41-40=Rs.1 Factors: Stability of the exchange rate depth of the market-volume of transaction

High volume(deep market)-narrow spread Low volume (thin market)-wider spread

Foreign Currency Accounts

Foreign Currency Accounts NOSTRO Account VOSTRO Account LORO Account

 NOSTRO ACCOUNT- It is the account maintained by any

Indian Bank abroad in foreign currency. The Latin meaning of NOSTRO is Our account our money with you OSTRO ACCOUNT- his is the account which foreign V T bank maintains in India in Indian Rupee. Latin meaning of VOSTRO is your account your money with us LORO ACCOUNT - It is an account where third party account is maintained. The Latin meaning of LORO account is there account with you MIRROR ACCOUNT- As clear from the name itself it is the mirror of the nostro account maintained in foreign currency and rupee also for the reconciliation purpose

Forex Transaction
Purchase Sale

Bank

Bank

Acquire Foreign Currency

Part with Home Currency

Acquire Home Currency

Part with Foreign Currency

Types of Transaction and market

The dealer deals in Forex market and the sub markets: Cash market: Value date- T+0 Tom market: Value date- T+1 Spot market: Value date- T+2 (sale & purchase of currency for immediate delivery; settlement within 2 days) Forward market:- T+n (settled on future specified date decided upfront; Over the Counter market) Future market:- T+n (settled on future specified datedecided upfront; Mark to Market, exchange traded) Options market-T is decided by option buyer based on or up to the maturity at the strike price

Types of Transaction and market

Swaps market: T+n decided upfront and exchange of cash

flow in two different currencies. Packing Credit Foreign Currency (PCFC)/Foreign Currency Non-Resident (Bank)FCNR(B) and External Commercial Borrowing (ECB) loans Money market operations: The surplus foreign currency fund as well as rupee swapped into foreign currency is placed in money market to earn interest Cross Currency Market: Apart from USD/INR other currencies are quoted, traded and rates are given as by the market maker

DEALING ROOM
The forum where all transactions related to foreign exchange in a

bank are carried out All professionals who deal in Currencies, Options, Futures and Swaps assemble in the Dealing Room The dealing room chief manages and co-ordinates all the activities and acts as link pin between dealers and higher management Reasons for concentration of entire information and communication system in a single room: enable dealers to have instant access to the rates quoted at different places To communicate and know the limits of each counterparty. This helps in making arbitrage gains

FRONT OFFICE AND BACK OFFICE

THE FRONT OFFICE

Dealers working directly in the market and located in the

Dealing Rooms of big banks They meet clients regularly and advise them regarding the strategy to be adopted with regard to their treasury management Role of the Front Office is to make profit from the operations on currencies The operations of front office are divided into several units: Sections for money markets and interest rate operations for spot rate transactions forward market transactions currency options dealing in futures

THE FRONT OFFICE

The role of dealers is two fold:

to manage the positions of clients

To quote bid-ask rates without knowing whether a

client is a buyer or seller Dealers buy or sell on behalf of the clients and make profit for the bank They take into account: the position that the bank has already taken and the effect that a particular operation might have on that position They also need to consider the limits fixed by the bank with respect to each single operation or single counterparty or position in a particular currency

THE BACK OFFICE

Activities: Managing the information system,

accounting, control, administration, and follow-up of the operations of Front Office It conceives of better information and control system relating to financial operations Ensures an effective financial and management control of market operations The Front Office and Back Office function in a symbiotic manner, on equal footing

Global Scenario

Contd.
Of the $4 trillion daily global turnover

trading in London accounted for around $1.36 trillion

(34.1%), making London the global center for foreign exchange For second and third places respectively, trading in New York accounted for 0.67 trillion (16.6%), and Tokyo accounted for 0.24 trillion (6.0%)

Ten most active traders

On the spot market, according to the BIS study, the most heavily traded products were: EUR/USD: 27% USD/JPY: 13% GBP/USD: 12%

Indian Forex Market Scenario

Forex average daily turnover was contributing 0.23% of total global turnover -2001 0.34% in 2004 It became 0.69% in 2007 The break-up of the transactions are as follows: 42.6% transactions are on spot market 27.5% in outright forward market 29.8% under the forex swap market

Income of Public Sector Banks (Forex)

2005-06 Bank of India Bank of Baroda Canara Bank Union Bank of India Punjab National Bank 182.31 178.19 154.78 149.77 122.1 2006-07 224.08 239.28 173.1 198.39 176.72 2007-08 306.58 278.79 153.64 261.2 211.39

FOREX RISK MANAGEMENT

Forex market is one of the most volatile financial market The various kind of risk linked to the Forex markets are:

MARKET RISK OPERATIONAL RISK CREDIT RISK

MARKET RISK
Exchange risk: Appreciation or depreciation of currencies Arises due to mismatch of amounts of assets and liabilities

as well as from the mismatch of maturity dates of assets or liabilities Open position Risk: The main source of Forex risk is open position in individual currencies It is completely un-hedged exposure in a particular currency Mitigated by doing complete cover operations, immediately in the same currency by taking opposite position

MARKET RISK
Gap Risk: Period mismatch in the currency pair result in interest rate

risk Eg bank has long position in USD/INR for three months while short in USD/INR for six months for the same amount, so this creates exchange / interest rate risk (IRR) or gap risk Interest rate risk may be of: Basis Risk: Imperfect correlation between the indices of underlying assets and liabilities Yield curve risk: Different rate shock for different bucket Re-pricing risk: Due to mismatch in asset & liability duration Settlement Risk: Such risk arises from time differences between trading zones i.e debit and credit are not synchronized Country Risk: Also called sovereignty risk. This arises when the exposed country will not be able to honour obligation due to shortage of foreign exchange or political risk

OPERATIONAL RISK
This covers the entire gamut of Forex transaction. It may

be divided into those arising from: Risk arose through work and document flow Non-compliance of guidelines & procedure specified for dealing & settlement Fraudulent attempt or practices Technology enabled risk (Hardware & software) Legal Risk is a risk where the transaction is not valid and enforceable, under the applicable (relevant local and other international) law Event Risk: unexpected/ sudden happening like 26/11 terror attack in Mumbai

CREDIT RISK
Arises from the possibility of a counter-party making

default in payment either interest or principal or both Also includes non-performance of obligation even for the off-balance sheet contracts Mitigated by fixing the limits (either by tenure wise or product wise or both) of operations per clients, based on the creditworthiness of the client by doing the rating of counter-party Mitigation can be done by better credit appraisal, careful analysis of cash flow of the counterparty business, etc

Recommendations for increasing Volume

The corporates may be permitted to take a hedge

upon declaring the existence of an exposure Allowing exporters to retain 100 per cent of their export earnings in any foreign currency with an Authorised Dealer (AD) The Reserve Bank should invite detailed proposals from banks for offering rupee-based derivatives

should refocus exchange control regulation and guidelines on risks rather than on products frame a fresh set of guidelines for foreign exchange and derivatives risk management