" Forein Exchange "

 

 

The participants of forex markets comprises of,

·         Corporates

·         Commercial Banks

·         Exchange Brokers

·         Central Banks

 

 

Corporates: The business houses, international investors and multinational corporations may operate in the market to meet their genuine trade or investment requirements. They may also speculate in foreign currencies to the extent permitted by exchange control regulations.

 

 

Commercial Banks: They are the major player in the forex market. They buy and sell currencies for their clients. They may also operate on their own. When a bank enters a market to correct excess sale or purchase position in a foreign currency arising from its various deals with its customers, it is said to do a cover operation. Such transactions constitutes around 5% of the total transaction done by large banks. A major portion of the volume is accounted by trading done by large banks to gain from forex movements.

 

 

The foreign exchange dealings of Commercial Banks in India are subjected to rules, regulations and guidelines of Reserve Bank of India (RBI) and Foreign Exchange Dealers Association Of India, popularly known as FEDAI.

 

 

Exchange Brokers: Large transactions are done by banks directly amongst themselves. For smaller transactions intermediation of forex broker may be sought. Exchange brokers facilitates deals between banks. In the absence of the broker banks will have to obtain quotes form all the banks, if say, there are 100 banks then quotes from 99 banks shall have to be obtained. Instead Exchange broker may be contacted who ensures that the most favourable quotation is obtained and at low cost in terms of time and money. The bank may specify to the broker the limit upto which the bank is willing to buy / sell foreign currency. The broker matches the requirements of the buying and the selling bank. The identity of the buying and the selling bank is revealed to each other by the exchange broker, only when the deal becomes acceptable to both the banks.

 

 

In India, banks may deal directly or through recognized exchange brokers authorized by RBI to carry out foreign exchange broking business. The exchange brokers are subjected to rules and regulations of FEDAI.

 

 

Central Banks: Central banks participate in the foreign exchange markets primarily for the following two purposes.

1.       To arrest volatility in the foreign exchange rates resulting from private supplies and demand, popularly known as intervention, by transacting on its own.

2.       To transact in the market on behalf of the Government.

 

RBI does not intervene in the ordinary course. It intervenes only when speculative forces dominates the market and rates becomes detrimental for the economy, trade and commerce.

 

 

 

 

Foreign exchange markets use latest developments in telecommunications for transmitting as well as settling foreign exchange transactions. The most popular settlement systems are as under,

 

·         SWIFT

 

·         CHIPS

 

·         CHAPS

 

·         Fedwire

 

 

SWIFT: Society for Worldwide Interbank Financial Telecommunication (SWIFT) is a co-operative society owned by about 250 banks in Europe and North America and registered as a co-operative society in Brussels, Belgium. It is a communication network for international financial market transactions linking more than 25000 financial institutions worldwide, who have been allotted bank identifier codes.

 

 

The messages are transmitted from country to country via central interconnected operating centers located in Brussels, Amsterdam and Culpeper, Virginia. The member countries are connected to the centers through regional processors in each country. The regional processor in India is situated in Mumbai.

 

 

The local bank in each country reaches the regional processors through the national networks.

 

 

The SWIFT system enables the member banks to transact amongst themselves quickly,

 

·         International payments

 

·         Statements

 

·         Other messages

 

The transmission of messages is within seconds thus it saves time and is economical.

 

 

 

1.       Reliable and time tested method of sending and receiving messages due to in built authentication facilities.

 

2.       Messages relay instantly enabling counterparty to respond immediately, except in case of time zone differences.

 

3.       Access available across the globe to launch new cross border initiatives.

 

 

CHIPS: Clearing House Inter-bank Payment System (CHIPS) is an electronic payment system owned by 12 private commercial banks constituting the New York Clearing House Association. CHIPS started operating from 1971 and grown into world’s largest payment system. Foreign Exchange and Euro-Dollar transactions are routed through CHIPS.

 

 

The functioning of CHIPS is illustrated with the help of following transaction. Bank Of India (BOI) maintaining a dollar account with AMEX Bank, New York, sells USD 1 million to Canara Bank, maintaining USD with CitiBank.

 

 

It may be noted that the settlement of the transactions in the New York Foreign Exchange market takes place in two stages. First, clearance at CHIPS and arriving at the net position of each bank. Second, transfer of FedFunds for the net position. The real balances are held by banks only with Federal Reserve Bank (FedFunds), central bank of US and the transaction is complete only when FedFunds are transferred. CHIPS helps in expediting the reconciliation and reducing the number of entries that pass through Fedwire.

 

 

CHAPS: Clearing House Automated Payment System (CHAPS) is similar to CHIPS existing in London.

 

 

FEDWIRE: Fedwire is a communication network that links the computers of about 7000 banks to the computers of Federal Reserve Banks. The transactions in New York Foreign Exchange market ultimately get settled through Fedwire. Fedwire funds transfer system are used primarily for domestic payments, bank to bank and third party transfers such as interbank overnight funds sales and purchases and settlement transactions. Corporate to corporate payments can also be made, but they should be routed through banks. Fed guarantees settlement of all payments sent to receivers even if sender fails.

 

 

 

The Foreign exchange transactions can be broadly classified into two types as under,

 

 

1.       Interbank Transactions: The foreign exchange dealings between banks themselves is known as interbank transactions and the exchange rate at which such transaction takes place is known as ‘Interbank Rate’ or simply ‘Market Rate’.

 

 

2.       Merchant Transactions: The foreign exchange dealings of bank with its customers is known as ‘Merchant Business’ or ‘Merchant Transactions’ and the exchange rate at which such transaction takes place is known as ‘Merchant Rate’.

 

 

 

Foreign currency is considered as a commodity in the foreign exchange dealings. Any trading has two aspects i.e. purchase and sale. The banks in India are authorized to deal in foreign exchange. Banks buys and sells its commodity i.e. foreign currency.

 

 

While discussing about foreign exchange two points should be borne in mind viz.

 

 

1.       The transaction is always considered from bank’s point of view, and

 

2.       The commodity referred to is foreign currency.

 

 

Therefore, when we say a purchase, we imply that

 

·               The bank has purchased, and

 

·               It has purchased foreign currency

 

Therefore, when we say a sale, we imply that

 

·               The bank has sold, and

 

·               It has purchased foreign currency

 

 

In a purchase transaction the bank acquires foreign currency and parts with home currency.

 

And in case of sale transaction the bank parts with foreign currency and acquires home

 

currency.

 

Exchange Rate: Exchange Rate is the price of one country’s currency expressed in terms of the currency of another country.

 

 

 

 

 

Exchange Rate may be quoted in either of two ways as under,

 

 

1.       Direct Quote: The quotation in which exchange rate is expressed as the price per unit of foreign currency in terms of home currency. For e.g. in case of India, US dollar shall be quoted as USD = Rs. 48.

In other words the variable unit is home currency, while the unit of foreign currency is held constant. It is also known as ‘Home Currency Quote’

 

1.       Indirect Quote: The quotation in which unit of home currency is kept constant and the exchange is expressed as so many units of foreign currency. For e.g. in case of India, Re = USD 0.02083.

 

 

The variable unit is foreign currency, while home currency is held constant. It is also known as ‘Foreign Currency Quote’ or simply ‘Currency Quote’.

 

 

The direct and indirect quotes are reciprocal of each other.

 

 

Indirect Quote = 1 / Direct Quote = 1 / 48 = USD 0.02083, and

 

 

Direct Quote = 1 / Indirect Quote = 1 / 0.02083 = Rs. 48.00

 

 

Banks in India follow direct quotes. In our discussion too we shall follow direct quote. Wherever indirect quotes are available, they shall be first converted into direct quote and then proceeded with.

 

 

 

In foreign exchange dealings “two way quotes” are quoted by the foreign exchange dealers, one for buying the foreign currency called ‘bid rate’ and another for selling foreign currency called ‘ask rate or offer rate’.

 

 

For e.g. USD = Rs. 48.1525 / 1650 i.e. Bid / Ask Rate

 

 

More often, the rate would be quoted as 1525 / 1650 since the players in the market are expected to know the ‘big number’ i.e. Rs. 48. In the given example bid rate is Rs. 48.1525 and the ask rate is Rs. 48.1650 per USD.

 

 

Some times quotes may be available in the form of mid rate. ‘Mid Rate’ is the average of bid and ask rate.

 

 

Since dealer expects to make profit in foreign exchange operations, two prices / rates quoted shall not be same. The dealer’s bid rate shall be lower than his ask rate. The difference between the ask rate and bid rate is known as ‘Spread’. In percentage terms spread can be expressed as under.

 

 

 

The spread is affected by a number of factors. The currency involved, the volume of the business and the market sentiments about the currency are the major factors according to the dealers that affects the spread.

 

 

American Terms Quote: When quote for foreign currency is expressed as number of USD per unit of another foreign currency then it is called American terms. For e.g. USD 0.9826 / Euro or USD 0.02083 / INR.

 

European Terms Quote: When foreign exchange rates are expressed as number of units of another currency per USD then it is called European Terms. For e.g. INR 48.00 / USD or CHF 1.3500 / USD.

 

 

Following are the world’s important currencies.

 

 

CROSS RATE: When exchange rate for a pair of currency is directly not available in the foreign exchange market then the exchange rate for such pair of currency is derived with the help exchange rate between USD and the currencies involved in the pair which is termed as Cross Rate.

 

 

Since USD is used to compute cross rate it is termed as vehicle currency. USD is most widely used currency and the exchange rate between USD and other currencies are available in the international foreign exchange markets.

 

 

Note: “Vehicle currency” is one which is used to compute cross rate between a pair of currencies whose exchange rates are directly not available.

 

 

For example an Indian importer has to pay New Zealand exporter in NZ$ and quote between INR & NZ$ is not available. The following quotes are available in the international market.

 

 

NZ$ / USD : 1.7908 – 1.8510

INR / USD : 48.0465 – 48.2111

 

 

The determination of INR / NZ$ exchange rate shall involve following steps.

 

1.       The Indian importer shall buy USD @ INR 48.2111.

 

2.       The Indian importer shall sell USD to buy NZ$. In other words the Indian importer gets NZ$ 1.7908 by selling 1 USD.

 

1.       In sum the Indian importer gets NZ$ 1.7908 in exchange for INR 48.2111. Therefore, the INR / NZ$ exchange rate shall be,

 

 

INR / NZ$ = Rs. 48.2111 / 1.7908 = INR 26.9215 / NZ$

 

 

The cross rate for bid and ask can be computed as under

 

 

NZ$ / USD : 1.7908 – 1.8510

 

 

INR / USD : 48.0465 – 48.2111

 

 

INR / NZ$ : 25.9571 – 26.9215

 

 

 

Before we discuss the types of transactions in foreign exchange market it is imperative to understand the definition of following terms,

 

 

·         Contract date: The date on which the two parties to the foreign exchange transaction agrees to exchange currencies.

 

 

·         Settlement Date or Value date: The day on which actual transfer of two currencies takes place at a previously agreed price on the contract date.

 

 

The transactions in foreign exchange markets are classified with respect to settlement dates as under,

 

 

1.   Cash Contracts i.e. Cash / Ready Transaction

 

2.   Spot Contracts i.e. Spot Transaction

 

3.   Forward Contracts i.e. Forward Transaction

 

4.   Swap Contracts i.e. Swap Transaction

 

 

 

Cash / Ready Transaction: Where the agreement to buy and sell is agreed upon and executed on the same date, the transaction is known as Cash or Ready transaction. It is also known as Value Today.

 

 

Spot Contract: The contract under which the exchange of currencies takes place two days after the contract date is known as spot contract. Under this value date termed as spot date is two days after the contract date.

 

 

Forward Contract: The contract under which the exchange of specified quantity of currency takes place at a specified future date, subsequent to spot date, at exchange rate agreed upon on contract date, is known as forward contract.

 

 

The forward contract can be for a delivery after one month, two months or three months from spot date, these are called standard forward contracts, which are for whole months.

 

 

Banks may offer forward contracts for maturities which are not whole months such as 45 days, 53 days, etc. Such contracts are called as ‘broken date’ or ‘odd date’ contracts.

 

 

The difference between the spot rate and the forward rate is called as Swap rate or Swap Points or Forward Margin. The annualized percentage difference between the spot rate and the forward rate is called Forward Premium or Discount. If the difference is positive, it is called forward premium and if the difference is negative, forward discount. In other words, if forward rates are higher than spot rate, than it indicates forward premium and if forward rates are lower than spot rate, it indicates forward discount.

 

 

 

n = No. of days for delivery from the spot date i.e. forward contract period.

 

 

Banks do not quote forward rate, rather they quote spot rate and forward margin. In case of direct quotation, premium is added to spot rate and discount is deducted from spot rate to arrive at forward rate for both purchase and sale transactions.

 

 

For instance, USD is quoted as under in the interbank market on 25^th January as under.

Spot          USD 1        =      INR 48.4000 / 4200

February                                       2000 / 2100

March                                         3500 / 3400

 

 

The above quotation should be understood as under.

 

·         First rate is spot rate, where 48.4000 is buying rate and 48.4200 selling rate.

 

·         Second and third statements are forward margins for February and March respectively.

 

·         Where the forward margin is given in ascending order, February in this case, it indicates that the foreign currency is at premium. The forward rate shall be computed by adding margin to the spot rate. Thus, the February forward rate shall be INR 48.6000 / 6300.

 

·         Where the forward margin is given in descending order, March in this case, it indicates that the foreign currency is at a discount. The forward rate shall be computed by deducting margin from the spot rate. Thus, the March forward rate shall be INR 48.0500 / 0800.

 

 

Swap Contracts: Simultaneous purchase and sale of identical quantity of a currency at different value dates is known as Swap Contract.

 

 

For instance, one bank enters into an agreement with another bank to buy JPY 1 million for USD in the spot market and also simultaneously agrees with the same bank to sell JPY 1 million for USD two months forward. The exchange rate, for both the transactions are agreed at the time of contract. This is a swap contract.

 

 

 

 

 

The term arbitrage refers to a process of buying currency in one market at lower prices and selling it in another at higher prices. Thus, difference in exchange rates in different markets provides an opportunity to the operators / arbitrageurs in the market to earn profit without risk.

 

 

 

 

In spot markets two types of arbitrages are possible viz,

 

 

1.       Geographical Arbitrage

 

2.       Triangular Arbitrage

 

 

Geographical Arbitrage: Geographical arbitrage consists of buying currency from a forex market, say Singapore, where it is cheaper and sell in another forex market, say France where it is costly.

 

 

For example at two forex centers, the following INR / USD rates are quoted

 

Singapore : INR 47.5730 – 47.6100

Tokyo :      INR 47.6350 – 47.6675

 

 

In the above example arbitrageur shall buy USD in Singapore market @ 47.6100 and sell in the Tokyo market @ 47.6350. The arbitrage profit shall be 47.6350 – 47.6100 = Re. 0.025 per USD.

 

 

The arbitrage opportunity exists when the bid rate in one market is higher than the ask rate in

another market.

 

If these lines do not overlap, then it means Ask Rate of one bank is lower than Bid rate of another bank and hence there is arbitrage opportunity.

 

 

Triangular Arbitrage: Triangular arbitrage takes place when there are three currencies involving three markets. This is also known as a ‘three-point arbitrage’. In other words, it is a process of buying and selling foreign exchange between three different currencies in order to profit from discrepancy in cross rates.

 

 

For example following quotes are available in three forex markets

GBP / USD: 0.6405 in Mumbai

NZ$ / GBP: 2.8606 in New Zealand

 

NZ$ / USD: 1.8402 in New York

 

 

The cross rate between NZ$ and USD can be quoted as under

 

 

NZ$ / USD = (NZ$ / GBP) x (GBP / USD) = NZ$ x USD = 2.8606 x 0.6405 = 1.8322

 

 

The given quote is 1.8402. Since there is a difference arbitrage gains are possible.

 

 

 

 

In spot market, the mismatch between cross rates (triangular) and quoted rates (geographical) provides an arbitrage opportunity. Similar arbitrage gain is possible in forward market also. Arbitrage gain shall exist when interest rate differentials of two currencies is not equal to the premium or discount on their exchange rate. Since the comparison is to be made with interest rate differential, this kind of arbitrage is referred to as “Covered interest arbitrage”

 

 

 

Determine the arbitrage gain where, spot rate of INR / GBP is Rs. 78.10, 3 month forward rate is Rs. 78.60, three months interest rates are Rs. 5% and £ 9%. Assume Rs. 10 million borrowings or £ 2,00,000 (as the case may be) to explain arbitrage.

 

 

Premium (%) = [(FR – SR) / SR] x 12/3 x 100 = [(78.60-78.10) / 78.10] x 12/3 x 100

 

 

Interest Rate Differential = 9% - 5% = 4%

 

 

Since interest rate differential do not match with premium percentage, there are arbitrage gain

possible as under,

 

1.   Borrow Rs. 10 million for 3 months @ 5% p.a. The amount to be repaid after 3 months is Rs. 10 million + interest = Rs. 10 million + Rs. 125,000 = Rs. 1,01,25,000/-.

 

2.   Convert borrowing of Rs. 10 million into GBP @ 78.10 spot i.e GBP 1,28,040.9731 today.

 

3.   Invest GBP 1,28,040.9731 for 3 months in US market @ 9% p.a.

 

4.   GBP available after 3 months is GBP 1,28,040.9731 + Interest = GBP 1,28,040.9731 + GBP 2880.9219 = GBP 1,30,921.8950

 

5.   Sell 3 months forward today GBP 1,30,921.8950 @ 78.60 today. Thus, amount available after 3 months = GBP 1,30,921.8950 x Rs. 78.60 = Rs. 1,02,90,460.95

 

6.   Arbitrage gain = Amount Available after 3 months – Amount Payable after 3 months

= 1,02,90,461 – 1,01,25,000 = Rs. 1,65,461/-

 

 

 

 

Since interest rate differential is 4%, the forward premium differential should also be 4% so

 

that no arbitrage gain exists. The desired forward rate should be.

 

 

 

Spot Rate                                                                           Rs. 78.100

 

Forward Rate                                                                      Rs. 78.881

 

 

 

 

The foreign exchange dealings of bank with its customers is known as ‘Merchant Business’ or ‘Merchant Transactions’ and the exchange rate at which such transaction takes place is known as ‘Merchant Rate’.

 

 

A bank buys foreign exchange from, and sells foreign exchange to, its customers as part of its routine business activity. When a bank buys foreign exchange (purchase transaction) from its clients it must sell the same to another (generally market i.e. inter-bank) at a rate better than purchase rate if it is to earn profit. Similarly, if the bank is to sell foreign exchange to its clients (sale transaction) it must buy foreign exchange from inter-bank market at a rate lower than that at which bank would eventually sell the same to its clients. Thus inter-bank buying rate and selling rate forms the basis for quoting buy rate and sell rate by the bank to its clients. Such inter-bank rate are referred to as ‘base rate’.

 

 

 

 

If the bank quotes the base rate to its client, it makes no profit. There are administrative costs involved. The deal first take place between client and bank, only after selling or acquiring the foreign exchange from / to client the bank goes to inter-bank market to cover the transaction. There is a time gap between merchant transaction and inter-bank transaction during this time gap there may be fluctuation in the exchange rate. Therefore, sufficient margin is built into the rate to cover administrative costs, rate fluctuation risk and profit margin this is referred to as

 

 

 

FEDAI prescribes exchange margin which were mandatory up to 1995, thereafter it is optional for banks to follow FEDAI prescribe exchange margin. Now, banks are free to decide their own Exchange Margin.

 

 

 

While computing merchant rates the calculations can be made up to 5 places of decimals and finally rounded off to the nearest multiple of 0.0025 both for buy and sell transactions.

 

 

The rupee amount to be paid to or received from client on account of merchant transactions should be rounded off to the nearest rupee, i.e. up to 49 paisa to be ignored and 50 to 99 paisa to be rounded off to the higher rupee.

 

 

 

 

In a purchase transaction bank acquires foreign exchange from clients and pays him in home currency (Indian Rupees). Some of the purchase transaction results in bank immediately acquiring foreign exchange such as Foreign Currency Demand Draft. On the other hand, if the bank purchases ‘on demand / at sight’ bill from its client, bank has to first send the bill to correspondent bank for collection. The correspondent bank will present the bill to drawee. Foreign exchange shall be acquired when the drawee makes payment. This time period is referred to as transit period (25 days as per FEDAI). Thus depending upon the time of realization of foreign exchange by the bank the two types of buying rates quoted in India are,

 

·         TT Buying Rate, and       (0.025% to 0.080%) – FEDAI Exchange Margin

·         Bill Buying Rate              (0.125% to 0.150%) – FEDAI Exchange Margin

 

Bills are of two types as under,

 

·         On demand / sight bill – where realization period is transit period (25 days as per FEDAI).

·         Usance Bill – where realization period is usance period + transit period.

 

When bank buys a bill from client, bank immediately pays him Indian Rupees. The bank is entitled to claim interest from client for the period of realization of bill. On the rupee value of the bill purchased, on the date of purchase itself, bank shall recover the interest and shall make net payment to the client.

 

When bank sells foreign exchange it receives Home Currency (Indian Rupees) from client and parts with foreign currency. The sale is affected by issuing a payment instrument on correspondent bank. Immediately on sale bank buys the requisite foreign exchange from inter-bank market. Depending on work involved there are two types of selling rates as under,

 

·         TT Selling Rates              (0.125% to 0.150%) – FEDAI Exchange Margin

·         Bill Selling Rates            (0.175% to 0.200%, over TT selling rate)