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Introduction to Foreign Exchange

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Title: Introduction to Foreign Exchange


1
Introduction to Foreign Exchange
  • Risks of International Finance
  • Foreign Exchange Risk
  • Understanding of this risk is essential to
    understand unforeseen volatility in foreign
    exchange rates
  • In domestic economy this risk is ignored because
    a single national currency serves as a medium of
    exchange within a country
  • This risk usually affects businesses that deals
    with export/import, but it can also affect
    investors making international investments. For
    example, if money must be converted to another
    currency to make a certain investment, then any
    changes in the currency exchange rate will cause
    that investment's value to either decrease or
    increase when the investment is sold and
    converted back into the original currency 
  • Political Risk
  • The risk of loss when investing in a given
    country caused by changes in a country's
    political structure or policies, such as tax
    laws, tariffs etc
  • The outcome of a political risk could drag down
    investment returns or even go so far as
    to withdraw capital from an investment

2
Introduction to Foreign Exchange
  • The extreme form of political risk is when the
    sovereign country changes the rules of the game
    and the affected parties have no alternatives
    open to them. Eg- In 1992, Enron Development
    Corporation signed a contract to build Indias
    longest power plant. Unfortunately, the project
    got cancelled in 1995 by the politicians in
    Maharashtra who argued that India did not require
    the power plant. The company had spent nearly
    300 mn on the project
  • The Enron episode highlights the problems
    involved in enforcing contracts in foreign
    countries
  • Political risk associated with international
    operations is generally greater than that
    associated with domestic operations and is
    generally more complicated
  • Expanded opportunity sets
  • When firms go global they tend to benefit from
    expanded opportunities which are availbale
  • They can raise funds in capital markets where
    cost of capital is the lowest
  • Firms can also gain from greater economies of
    scale when they operate on a global basis

3
Introduction to Foreign Exchange
  • Foreign Exchange Market
  • Foreign exchange market is the place where money
    denominated in one currency is bought and sold
    with money denominated in another currency
  • The foreign exchange market is a worldwide
    decentralized over-the-counter financial market
    for the trading of currencies.
  • The currencies and the extent of participation of
    each currency in this market depend on local
    regulations that vary from country to country
  • The foreign exchange market determines the
    relative values of different currencies.
  • The primary purpose of the foreign exchange is to
    assist international trade and investment, by
    allowing businesses to convert one currency to
    another currency.
  • The foreign exchange market is unique because of
  • its huge trading volume, leading to high
    liquidity
  • its geographical dispersion
  • its continuous operation 24 hours a day except
    weekends
  • the variety of factors that affect exchange rates

4
Introduction to Foreign Exchange
  • The foreign exchange market is the largest and
    most liquid financial market in the world.
    Traders include large banks, central banks,
    institutional investors, currency speculators,
    corporations, governments, other financial
    institutions, and retail investors
  • The foreign exchange market in India is
    relatively very small and is controlled and
    regulated by the RBI. The RBI plays a crucial
    role in settling the day-to-day rates
  • The foreign exchange market is of two types
  • Retail Market- Travellers and tourists exchange
    one currency for another
  • Wholesale Market- Large commercial banks, foreign
    exchange brokers, commercial customers primarily
    MNCs and central banks
  • Participants in Foreign Exchange
  • Commercial Banks
  • They are the major participants and provide the
    core of the market
  • These banks serve their customers in conducting
    foreign investment in financial assets that
    require foreign exchange

5
Introduction to Foreign Exchange
  • Foreign Exchange Brokers-Brokers in the Forex are
    the middle men between banks who trade currency
    on a daily basis. Brokers spend their day
    matching buy and sell orders between clients.
    Many of their functions are computerized, which
    means deals are done fast. Banks pay a fee to
    have these brokers handle their transactions
  • Central Banks- Central Banks frequently intervene
    in the market to maintain the exchange rate of
    their currencies within a desired range and into
    smooth fluctuations within that range
  • MNCs- They are the major non-bank participants
    in the forward market as they exchange cash flows
    associated with their multinational operations.
    MNCs often contract to either pay or receive
    fixed amounts in foreign currencies at future
    dates, so they are exposed to foreign currency
    risk
  • Individuals and small businesses- They use
    foreign exchange market to facilitate execution
    of commercial or investment transactions

6
Introduction to Foreign Exchange
  • Major Segments of the Foreign Exchange Market
  • Spot The market that completes the transaction
    on the spot and settlement typically within 48
    hours
  • Outright Forward The market in which agreement
    is reached at todays price but delivery at some
    specified future date
  • Swaps A market in which two transactions occur
    simultaneously the purchase (or sale) of a
    pre-determined amount of currency on one date and
    a reverse of the transaction on some future date
  • Futures Similar to the outright forward market,
    except that futures are traded through brokers on
    exchanges and executed with agreement terms
    describing the size of the transaction and
    delivery dates
  • Options The buyer has the right but not the
    obligation to buy or sell a currency at a defined
    strike price. Call options give the buyer the
    right to purchase a currency at some point in the
    future at a price agreed upon now.

7
Introduction to Foreign Exchange
  • Foreign Exchange Transaction
  • An FX transaction may be useful in managing the
    currency risk associated with importing or
    exporting goods and services denominated in
    foreign currency, investing or borrowing
    overseas, repatriating profits, converting
    foreign currency denominated dividends, or
    settling other foreign currency contractual
    arrangements.
  • How does an FX transaction work?
  • When you enter into an FX transaction, you
    nominate the amount and the two currencies to be
    exchanged. These currencies are known as the
    currency pair and must be acceptable to your
    foreign exchange provider.
  • You also nominate the maturity date on which you
    want the exchange of currencies to take place.
    Your FX provider will then determine the exchange
    rate, known as the contract rate, based on the
    date and currencies nominated by you. The
    contract rate is the rate at which the currencies
    will be exchanged.
  • On the contract date the contract amount must be
    exchanged with your FX provider at the contract
    rate, irrespective of where the foreign exchange
    rate is at the time.

8
Introduction to Foreign Exchange
  • How does your FX provider determine your contract
    rate?
  • It is the agreed exchange rate at which the
    currency pair will be exchanged on the date of
    maturity. Your currency provider determines the
    contract rate, taking several factors into
    account including
  • the currency pair and the time zone you choose to
    trade in
  • the maturity date set by you
  • inter-bank spot foreign exchange rates
  • the contract amount, and your currency providers
    ability to trade small amounts on the inter-bank
    market
  • market volatility
  • inter-bank interest rates of the countries of the
    currency pair.

9
Balance of Payment
  • Balance of Payment
  • BOP is an accounting record of all monetary
    transactions between a country and the rest of
    the world. These transactions include payments
    for the country's exports and imports of goods,
    services, and financial capital, as well as
    financial transfers
  • The BOP summarizes international transactions for
    a specific period, usually a year, and is
    prepared in a single currency, typically the
    domestic currency for the country concerned
  • When all components of the BOP sheet are included
    it must sum to zero with no overall surplus or
    deficit. For example, if a country is importing
    more than it exports, its trade balance will be
    in deficit, but the shortfall will have to be
    counter balanced in other ways such as by funds
    earned from its foreign investments, by running
    down reserves or by receiving loans from other
    countries
  • BOP helps to understand the performance of each
    countrys economy in international market. It
    helps business people identify emerging markets,
    understand market competitiveness and helps
    policy maker to define new policies according to
    market trend. It also helps policy maker to watch
    and act as feedback system for their newly
    implemented policies

10
Balance of Payment
  • It also gives exporters and importers good
    knowledge about international market transactions
    and tend to plan their business better. It also
    reflects country export and import potential and
    in turn helps business analysts to monitor
    international market
  • When the central bank buys domestic currency and
    sells the foreign reserve currency in the private
    FOREX the transaction indicates a BOP deficit
  • When the central bank sells domestic currency and
    buys foreign currency in the FOREX the tranaction
    indicates a BOP surplus
  • BOP Accounting
  • Balance of payments accounting system is an
    accounting system design to track buy and sell
    transactions between countries by an individuals,
    businesses and government agencies
  • It is double entry system in which each
    transaction creates a credit entry and a debit
    entry of equal value. Buying goods and services
    creates debit entries and selling things produces
    credits entries
  • BOP records only those transactions that has some
    monetary value. It records transactions done in
    certain period of time, say for a year. It
    records transactions between residents of one
    country and residents of other countries.
    Residents can be individuals, businesses or
    government agencies

11
Balance of Payment
  • Components of BOP
  • BOP system consists of three major accounts
  • current account- The current account records four
    types of transactions exports and imports of
    merchandise, exports and imports of services,
    investment income and gift between residents of
    different countries
  • capital account
  • It is an accounting measure of the total domestic
    currency value of financial transactions between
    domestic residents and the rest of the world over
    a period of time. Capital account can be divided
    into 3 categories
  • Direct Investment- Investor acquires equity such
    as purchases of stocks, acquisition of entire
    firms or the establishment of new subsidiaries.
  • Portfolio Investment- It represents sales and
    purchases of foreign financial assets such as
    stocks and bonds that do not involve a transfer
    of management control
  • Capital flows- represent claims with a maturity
    of less than one year such as bank deposits,
    short-term loans, money market investments etc

12
Balance of Payment
  • official reserve account- Official reserves are
    government owned assets. It represents purchases
    and sales by the central bank of the country.
  • If a country has a BOP deficit, the central bank
    will have to either run down its official reserve
    assets such as gold, foreign exchange etc or
    borrow fresh from foreign central banks.
  • If a country has a BOP surplus, its central bank
    will either acquire additional reserve assets
    from foreigners or retire some of its foreign
    debts.

13
International Financial Institutions
  • International Monetary Fund(IMF)
  • IMF is a cooperative institution that 182
    countries have voluntarily joined because they
    see the advantage of consulting with one another
    on this forum to maintain a stable system of
    buying and selling their currencies so that
    payments in foreign currency can take place
    between countries smoothly and without delay
  • IMF lends money to members having trouble meeting
    financial obligations to other members, but only
    on the condition that they undertake economic
    reforms to eliminate these difficulties for their
    own good and that of the entire membership
  • IMF has no effective authority over the domestic
    economic policies of its members
  • IMF members are required to disclose information
    about its monetary and fiscal policies and avoid
    putting restrictions on exchange of domestic for
    foreign currency and on making payments to other
    members
  • On joining the IMF, each member country
    contributes a certain sum of money called a
    quota subscription, as a sort of credit union
    deposit.

14
International Financial Institutions
  • Quotas serve various purposes-
  • They from a pool of money that the IMF can draw
    from to lend to members in times of financial
    difficulty
  • They form the basis of determining the Special
    Drawing Rights(SDR)
  • They determine the voting power of the member in
    IMF decisions
  • It works to foster global monetary cooperation,
    secure financial stability, facilitate
    international trade, promote high employment and
    sustainable economic growth, and reduce poverty
    around the world
  • The IMF's fundamental mission is to help ensure
    stability in the international system. It does so
    in three ways keeping track of the global
    economy and the economies of member countries
    lending to countries with balance of payments
    difficulties, and giving practical help to
    members
  • The IMF provides loans to countries that have
    trouble meeting their international payments and
    cannot otherwise find sufficient financing on
    affordable terms
  • The IMF also provides concessional loans to
    low-income countries to help them develop their
    economies and reduce poverty

15
International Financial Institutions
  • They provide technical assistance in certain
    areas of its competence
  • Running an educational institute in Washington
    and offering training courses abroad
  • Issuing wide variety of publications containing
    valuable information and statistics that are
    useful not only to the member countries but also
    to banks, research institutes, university and the
    media
  • SDR
  • SDRs are supplementary foreign exchange reserve
    assets maintained by the IMF.
  • Not a currency, SDRs instead represent a claim
    to currency held by IMF member countries for
    which they may be exchanged
  • They can only be exchanged for Euros, Japanese
    yen, UK pounds, or US dollars,
  • They keep SDR available for need of payments that
    must be made in foreign exchange
  • A nation with a balance of payments need may use
    its SDRs to obtain usable currency from another
    nation designated by the fund

16
International Financial Institutions
  • Mechanisms used by the IMF to lend money are
  • Standby Arrangements
  • They are designed to provide short term balance
    of payments assistance for deficits of a
    temporary nature, such arrangements are typically
    for 12 to 18 months
  • Drawings are phased on a quarterly basis, with
    their release made conditional on meeting
    performance criteria and the completion of
    periodic program reviews
  • Extended Fund Facility
  • It is designed to support medium-term programmes
    that generally run for 3 years
  • It aims at overcoming balance of payments
    difficulties stemming from macroeconomic and
    structural problems

17
International Financial Institutions
  • Enhanced Structural Adjustment Facility
  • To provide resources to low income countries for
    longer periods on concessional terms
  • Compensatory and Contingency Financing Facility
  • It provides compensatory financing for members
    experiencing temporary export shortfalls or
    excesses in cereal import costs as well as
    financial assistance for external contingencies
  • Supplemental Reserve Facility
  • It provides financial assistance for exceptional
    balance of payments difficulties due to a large
    short-term financing need resulting from a sudden
    and disruptive loss of market confidence

18
International Financial Institutions
  • World Bank
  • The World Bank is an international financial
    institution that provides loans to developing
    countries for reconstruction and development. The
    World Bank has a goal of reducing poverty
  • The bank uses its financial resources, its highly
    trained staff and its extensive knowledge base to
    individually help each developing country onto a
    path of stable, sustainable and equitable growth
  • The bank emphasises the need for investing in
    people, particularly through basic health and
    education, protecting the environment, supporting
    and encouraging private business development,
    strengthening the ability of the governments to
    deliver quality services efficiently and
    transparently, promoting reforms to create a
    stable macroeconomic environment conducive to
    investment and long term planning, focusing on
    social development
  • The bank is also helping countries to strengthen
    and sustain the fundamental conditions that help
    to attract and retain private investment
  • All of its decisions must be guided by a
    commitment to promote foreign investment,
    international trade and facilitate capital
    investment.

19
International Financial Institutions
  • The bank helps governments in financing
    unemployment compensation, job creation schemes
    and retraining programs
  • The World Bank differs from the World Bank Group,
    in that the World Bank comprises only two
    institutions the International Bank for
    Reconstruction and Development (IBRD) and the
    International Development Association (IDA),
    whereas the latter incorporates these two in
    addition to three moreInternational Finance
    Corporation (IFC), Multilateral Investment
    Guarantee Agency (MIGA), and International Centre
    for Settlement of Investment Disputes (ICSID).
  • What is the difference between the world bank and
    a commercial bank
  • It lends and even manages funds much like a
    regular bank,
  • It is owned by 184 countries.
  • The financial support and advice the World Bank
    provides its member countries is designed to help
    them fight poverty
  • Unlike commercial banks, the World Bank often
    lends at little or no interest to countries that
    are unable to raise money for development
  • Countries that borrow from the World Bank also
    have a much longer period to repay their loans
    than commercial banks allow.
  • World Bank can borrow money at low interest rates
    from capital markets all over the world and
    channel it to developing countries

20
International Financial Institutions
  • What is the difference between the World Bank and
    the IMF-pg 28
  • IBRD
  • The IBRD was set up in 1945 along with the IMF
    whose original mission was to finance the
    reconstruction of nations devastated by World War
    II. Now, its mission has expanded to fight
    poverty by means of financing states
  • IBRD lends money to a government for the purpose
    of developing that countrys economic
    infrastructure such as roads and power generating
    facilities
  • Funds are lent only to members of IMF, usually
    when private capital is unavailable at reasonable
    terms.
  • The funds for this lending come primarily from
    the issuing of World Bank bonds on the global
    capital marketstypically 1215 billion per
    year. These bonds are rated AAA because they are
    backed by member states' share capital, as well
    as by borrowers' sovereign guarantees.
  • Because of the IBRD's credit rating, it is able
    to borrow at relatively low interest rates. As
    most developing countries have considerably lower
    credit ratings, the IBRD can lend to countries at
    interest rates that are usually quite attractive
    to them, even after adding a small margin (about
    1) to cover administrative overheads.

21
International Financial Institutions
  • International Development Association(IDA)
  • It is responsible for providing long-term,
    interest-free loans to the world's poorest
    countries
  • Credit terms are usually extended to 40 to 50
    years with no interest
  • Repayment begins after a ten-year grace period
    and can be paid in the local currency as long as
    it is convertible
  • While the IBRD raises most of its funds on the
    world's financial markets, IDA is funded largely
    by contributions from the governments of the
    richer member countries
  • IDA loans address primary education, basic health
    services, clean water supply and sanitation,
    environmental safeguards, business-climate
    improvements, infrastructure and institutional
    reforms. These projects are intended to pave the
    way toward economic growth, job creation, higher
    incomes and better living condition

22
International Financial Institutions
  • International Finance Corporation(IFC)
  • It shares the primary objective of improving the
    quality of the lives of people in its developing
    member countries
  • IFC is the largest multilateral source of loan
    and equity financing for private sector projects
    in the developing world. It promotes sustainable
    private sector development primarily by
  • Financing private sector projects and companies
    located in the developing world
  • Helping private companies in the developing world
    mobilize financing in international financial
    markets
  • Providing advice and technical assistance to
    businesses and governments
  • Loans are made to private firms usually for a
    period of seven to twelve years
  • Multilateral Investment Guarantee Agency(MIGA)1
  • MIGA promotes foreign direct investment into
    developing countries by insuring investors
    against political risk, advising governments on
    attracting investment, sharing information
    through on-line investment information services,
    and mediating disputes between investors and
    governments

23
International Financial Institutions
  • Asian Development Bank(ADB)
  • It is a regional development bank to facilitate
    economic development of countries in Asia, reduce
    poverty and improve the quality of life of their
    people
  • ADB will follow three complementary strategic
    agendas inclusive growth(implies an equitable
    allocation of resources with benefits accruing to
    every section of society, which is a utopian
    concept ), environmentally sustainable growth and
    regional integration
  • In pursuing its vision, ADBs main instruments
    comprise loans, technical assistance, grants,
    advice and knowledge

24
International Financial Institutions
  • World Trade Organisation
  • WTO gives an opportunity to the nations to sit
    together and talk trade
  • WTO provides data of tariff and trade to
    developing nations to help them in their export
  • It provides information and advice on export
    markets and marketing techniques. It helps in
    establishing export promotion and marketing
    services and in training personnel required for
    these services
  • The WTO administers the Understandings on Rules
    and Procedures governing the Settlement of
    Disputes
  • With a view to achieving greater coherence in
    global economic policy-making, the WTO cooperates
    as appropriate, with the International Monetary
    Fund (IMF) and with the International Bank for
    Reconstruction and Development (World Bank) and
    its affiliate agencies
  • It disseminates information to the public about
    the developments in WTO through its publication
    and its websites

25
Exchange rate mechanism
  • Evolution of the International Monetary System
    can be analysed in four stages
  • Gold standards(1876-1913)
  • Gold was used as storage of wealth and as a
    medium of exchange
  • Each country had to establish the rate at which
    its currency could be converted to the weight of
    gold
  • The exchange rate between any two currencies was
    determined by their gold content
  • Eg- Pg 42
  • Inter-war Years(1914-1944)
  • War interrupted trade flows and disturbed the
    stability of exchange rates for currencies of
    major countries
  • Widespread fluctuation in currencies in terms of
    gold
  • As countries began to recover from the war and
    stabilise their economies, they made several
    attempts to return to the gold standard
  • The key currency involved in the attempt to
    restore the international gold standard was the
    pound sterling which returned to gold in 1925 at
    4.86 which was overvalued

26
Exchange rate mechanism
  • Pounds overevaluation, failure of the US to act
    responsibly, underevaluation of the French franc
    and decrease in willingness and ability of
    nations to rely on gold standard
  • Bretton Woods System(1945-1972)
  • Revival of the system was necessary and the
    reconstruction of the post-war financial system
    began with the Bretton Woods Agreement that
    emerged from the International Monetary and
    Financial Conference in July 1944 at Bretton
    Woods
  • There was a general agreement that restoring the
    gold standard was out of question
  • Governments needed access to credits in
    convertible currencies if they were to stabilise
    exchange rates
  • Governments should make major adjustments in
    exchange rates only after consultation with other
    countries
  • A monetary system was needed that would recognise
    that exchange rates were both a national and an
    international concern

27
Exchange rate mechanism
  • The agreement established a dollar based
    International Monetary System and created two new
    institutions
  • International Monetary Fund(IMF)- To help
    countries with balance of payments and exchange
    rate problems
  • International Bank for Reconstruction and
    Development(World Bank)- To help countries with
    post-war reconstruction and general economic
    development
  • The basic purpose of this new monetary system was
    to facilitate the expansion of world trade and to
    use the US dollar as a standard of value
  • No provision was made for the US to change the
    value of gold at 35 per ounce
  • Each country was obligated to define its monetary
    unit in terms of gold or dollars
  • Each currency was permitted to fluctuate within
    plus or minus one percent of par value by buying
    or selling foreign exchange and gold as needed
  • In order to keep market exchange rates within 1
    of par value, central banks and exchange
    authorities would have to build up to a stock of
    dollar reserves with which to intervene in the
    foreign exchange market
  • Countries would have to make a payment of gold
    and currency to the IMF in order to become a
    member.
  • Flexible Exchange Rate Regime
  • Crawling Peg
  • A system of exchange rate adjustment in which a
    currency is allowed to fluctuate within a band of
    rates
  • The disadvantage of this system is that it
    requires countries to have ample reserves for the
    prolonged process of adjustment
  • Wide Band

28
Exchange rate mechanism
  • Flexible Exchange Rate Regime,(1973-Present)
  • Most countries allowed their currencies to float
    with government intervention in the foreign
    exchange market
  • A cross between a fixed rate system and a fully
    flexible system are the semi-fixed systems such
    as the crawling peg and the wide band.
  • They differ from fixed rates because of their
    greater flexibility in terms of the exchange rate
    movement. But they are not a floating system
    either because there is still a limit with regard
    th how far the exchange rate can move
  • Crawling Peg- To adjust the rate slowly by small
    amounts at any point in time on a continuous
    basis to correct for any overevaluation and
    undervaluation
  • It was designed to discourage speculation by
    setting an upper limit that speculators could
    gain from devaluation in one year(0.5 a month or
    6 for the whole year)
  • The disadvantage of this system is that it
    requires countries to have ample reserves for the
    prolonged process of adjustment. Also the minor
    adjustments may not correct the currencys
    overevaluation or undervaluation

29
Exchange rate mechanism
  • Wide Band- It allows the currency value to
    fluctuate by say 5 on each side of the par
  • Under a flexible system, the market force, based
    on demand and supply determines a currencys
    value
  • In the absence of government intervention, the
    float is said to be clean. It becomes dirty
    when there is a central bank intervention to
    influence exchange rates
  • Advantages of Floating Exchange Rates
  • BOP disequilibrium will tend to be automatically
    rectified by a change in the exchange rate
  • Floating rate allows governments freedom to
    pursue their own internal policy objectives such
    as growth and full employment
  • Gives flexibility in determining interest rates

30
Exchange rate mechanism
  • Evolution of Exchange Rate Mechanism in India-
    Spot and forward markets
  • Foreign exchange market in India came into
    existence in 1978, when RBI permitted banks to
    undertake intra-day trading in foreign exchange
  • For profit opportunities banks began quoting two
    way prices against rupee as well as in cross
    currencies
  • Foreign exchange dealers association (FEDA) lays
    down the rules for fixation of commissions and
    other charges
  • Foreign exchange market comprises four segments
  • Apex segment- RBI and ADs(banks authorised by RBI
    to undertake foreign exchange business)
  • Inter-bank segment- Transactions of the ADs among
    themselves and with overseas banks
  • Primary segment- Transactions of the ADs with
    customers
  • Licensed money changers and travel agents

31
Foreign Exchange Management Act
  • FERA was replaced by FEMA in 2000
  • Difference between FERA and FEMA
  • The object of FERA was to conserve foreign
    exchange and to prevent its misuse. FEMA combines
    and improves the laws relating to foreign
    exchange. It makes the procedure for foreign
    investment easy and consequently encourages
    foreign exchange in India.
  • Under FERA, any offence was a criminal one which
    included imprisonment. Under FEMA, offence is
    treated as civil offence where a penalty has to
    be paid in terms of money and imprisonment is
    only for those people who do not pay the penalty.
  • The monetary penalty payable under FERA, was
    nearly the five times the amount involved. Under
    FEMA the quantum of penalty has been considerably
    decreased to three times the amount involved
  • Offences under FERA were not compoundable, while
    offences under FEMA are compoundable.
    Compoundable offences are those which can be
    compromised by the parties to the dispute without
    the permission of the court
  • Citizenship was a criterion to determine
    residential status under FERA but to determine
    residential status under FEMA, one has to stay in
    India for more than 182 days

32
Foreign Exchange Management Act
  • Authorised Dealers
  • Generally all nationalised banks and foreign
    banks are appointed as Authorised Dealers to
    deal in foreign exchange
  • Money changers are authorised by the RBI only to
    purchase foreign currency in the form of
    travelers cheques, notes or coins or sale of
    foreign currency in the form of coins and notes

33
Foreign Exchange Management Act
  • FEMA Regulation for Import of Goods and Services
  • ADs should not open L/C or allow remittances for
    import of goods included in the negative list
    requiring licence for imports
  • Any person acquiring foreign exchange is
    permitted to use it either for the purpose
    mentioned in the declaration made by him or for
    any other purpose for which acquisition of
    exchange is permissible
  • Where foreign exchange acquired has been utilised
    for import of goods into India the AD should
    ensure that importer furnishes an evidence of
    import to his satisfaction
  • remittances against imports should be completed
    not later than six months from the date of
    shipment except in cases where amounts are
    withheld towards guarantee of performance etc
  • Authorised Dealers may permit settlement of
    import dues delayed due to disputes, financial
    difficulties etc
  • In cases where the importer is unable to obtain
    bank guarantee from overseas suppliers and the AD
    is satisfied about the track record and bona
    fides of the importer, the requirement of the
    bank guarantee/ standby Letter of Credit may not
    be insisted upon for advance remittances upto USD
    1,000,000

34
Foreign Exchange Management Act
  • Where imports are made in non-physical form,
    i.e., software or data through internet/datacom
    channels and drawings and designs through
    e-mail/fax, a certificate from a Chartered
    Accountant that the software/data/drawing/design
    has been received by the importer, may be
    obtained.
  • Authorised Dealers should advise importers to
    keep Customs Authorities informed of the imports
    made by them
  • In case an importer does not furnish any
    documentary evidence of import, as required
    within 3 months from the date of remittance
    involving foreign exchange exceeding USD100,000,
    the Authorised Dealer should rigorously follow-up
    for the next 3 months, including issue of
    registered letters to the importer.
  • Authorised Dealers should forward to Reserve Bank
    a statement on half-yearly basis as at the end of
    June December of every year furnishing details
    of import transactions, exceeding USD 100,000 in
    respect of which importers have defaulted in
    submission of appropriate document evidencing
    import within 6 months from the date of
    remittance.

35
Foreign Exchange Management Act
  • Gold may be imported by the nominated
    agencies/banks on consignment basis where the
    ownership will remain with the supplier and the
    importer (consignee) will be acting as an agent
    of the supplier (consignor). Remittances towards
    the cost of import shall be made as and when
    sales take place and in terms of the provisions
    of agreement entered into between the overseas
    supplier and nominated agency/bank.
  • Authorised Dealers should ensure that due
    diligence is undertaken and all
    Know-Your-Customer (KYC) norms and the
    Anti-Money-Laundering guidelines are adhered to
    while undertaking import gold transactions. Any
    large or abnormal increase in the volume of
    business of the importer should be closely
    examined to ensure that the transactions are bona
    fide trade transactions
  • Nominated agencies/approved banks can import gold
    on loan basis for lending to exporters of
    jewellery under this scheme. On the other hand
    EOUs and units in SEZ who are in the Gem and
    Jewellery sector can import gold on loan basis
    for manufacturing and export of jewellery on
    their own account only.

36
Foreign Exchange Management Act
  • Know Your Customer (KYC) guidelines and Anti
    Money Laundering (AML)
  • This policy document is prepared in line with the
    RBI guidelines and incorporate the Bank's
    approach to customer identification procedures,
    customer profiling based on the risk perception
    and monitoring of transactions on an ongoing
    basis.
  • The objective of KYC guidelines is to prevent the
    Bank from being used, intentionally or
    unintentionally, by criminal elements for money
    laundering activities.
  • Obligations under Prevention of Money Laundering
    PML act 2002
  • (i) maintaining a record of prescribed
    transactions(ii) Furnishing information of
    prescribed transactions to the specified
    authority(iii) Verifying and maintaining records
    of the identity of its clients(iv) Preserving
    records in respect of (i), (ii), (iii) above for
    a period of 10 years from the date of cessation
    of transactions with the clients

37
Foreign Exchange Management Act
  • Policy Objectives
  • (i) To prevent criminal elements from using the
    Banking System for money laundering
    activities.(ii) To enable the Bank to
    know/understand the customers and their financial
    dealings better, which in turn would help the
    Bank to manage risks prudently.(iii) To put in
    place appropriate controls for detection and
    reporting of suspicious activities in accordance
    with applicable laws/laid down procedures.(iv)
    To comply with applicable laws and regulatory
    guidelines.(v) To take necessary steps to ensure
    that the concerned staff are adequately trained
    in KYC/AML procedures.
  • Key Elements of the Policy
  • Customer Acceptance Policy
  • The Bank will(i) Classify customers into
    various risk categories and based on risk
    perception decide on acceptance criteria for each
    category of customers(ii) accept customers
    after verifying their identity as laid down in
    Customer Identification Procedures(iii)not open
    accounts in the name of anonymous / fictitious
    /persons(iv) strive not to inconvenience the
    general public, especially those who are
    financially or socially disadvantaged.

38
Foreign Exchange Management Act
  • Customer Identification Procedures
  • The first requirement of customer identification
    procedure is to be satisfied that a prospective
    customer is who he/she claims to be
  • The second requirement of customer identification
    procedures is to ensure that sufficient
    information is obtained on the nature of the
    business that the customer expects to undertake
    and any expected or predictable pattern of
    transactions.The information collected will be
    used for profiling the customer
  • Customers will be classified into three risk
    categories namely High, Medium and Low, based on
    the risk perception. The risk categorization will
    be reviewed periodically.
  • Customer Identification will be carried out in
    respect of non-account holders approaching bank
    for high value one-off transaction as well as any
    person or entity connected with a financial
    transaction which can pose significant
    reputational or other risks to the Bank.

39
Foreign Exchange Management Act
  • Monitoring of Transactions
  • Monitoring of transactions will be conducted
    taking into consideration the risk profile of the
    account. Special attention will be paid to all
    complex, unusually large transactions and all
    unusual patterns, which have no apparent economic
    or viable lawful purpose
  • Risk Management
  • While the bank has adopted a risk based approach
    to the implementation of this Policy. It is
    necessary to establish appropriate framework
    covering proper management oversight, systems,
    controls and other related matters.
  • Banks Internal Audit of compliance with KYC/AML
    Policy will provide an independent evaluation of
    the same including legal and regulatory
    requirements. Concurrent/Internal Auditors shall
    specifically check and verify the application of
    KYC/AML procedures at the branches and comment on
    the lapses observed in this regard. The
    compliance in this regard will be placed before
    the Audit Committee of the Board at quarterly
    intervals
  • All employee training programmes will have a
    module on KYC Standards AML Measures so that
    members of the staff are adequately trained in
    KYC/AML

40
Foreign Exchange Management Act
  • Principal Officer Money Laundering Reporting
    Officer
  • Bank will designate a senior officer as Principal
    Officer who shall be responsible for
    implementation of and compliance with this
    policy.His illustrative duties will be as
    follows  Monitoring the implementation of the
    banks KYC/AML policy. Reporting of
    transactions and sharing of the information as
    required under the law. Maintaining liaison
    with law enforcement agencies. Ensuring
    submission of periodical reports to the top
    Management / Board.
  • Pg-73
  • Foreign Exchange Markets- Pg 77

41
Parties in International Finance
  • Purchasing power parity
  • Purchasing power parity (PPP) is a theory which
    states that exchange rates between currencies are
    in equilibrium when their purchasing power is the
    same in each of the two countries. This means
    that the exchange rate between two countries
    should equal the ratio of the two countries'
    price level of a fixed basket of goods and
    services. When a country's domestic price level
    is increasing (i.e., a country experiences
    inflation), that country's exchange rate must
    depreciated in order to return to PPP
  • The basis for PPP is the "law of one price".
  • For example, a particular TV set that sells for
    750 Canadian Dollars CAD in Vancouver should
    cost 500 US Dollars USD in Seattle when the
    exchange rate between Canada and the US is 1.50
    CAD/USD
  • Absolute purchasing power parity implies that "a
    bundle of goods should cost the same in Canada
    and the United States once you take the exchange
    rate into account". Any deviations from this (if
    a basket of goods is cheaper in Canada than in
    the United States), then we should expect
    relative prices and the exchange rate between the
    two countries to move towards a level at which
    the basket of goods have the same price in the
    two countries.

42
Parties in International Finance
  • Relative PPP describes differences in the rates
    of inflation between two countries.eg- suppose
    the rate of inflation in Canada is higher than
    that in the US, causing the price of a basket of
    goods in Canada to rise. Purchasing power parity
    requires the basket be the same price in each
    country, so this implies that the Canadian dollar
    must depreciate vis-a-vis the U.S. dollar. The
    percentage change in the value of the currency
    should then equal the difference in the inflation
    rates between the two countries. For example, if
    Canada has an inflation rate of 3 and the US has
    an inflation rate of 1, the Canadian Dollar will
    depreciate against the US Dollar by 2 per year.
  • Does PPP determine exchange rates in the short
    term? No. Exchange rate movements in the short
    term are news-driven. Announcements about
    interest rate changes, changes in perception of
    the growth path of economies and the like are all
    factors that drive exchange rates in the short
    run. PPP, by comparison, describes the long run
    behaviour of exchange rates. The economic forces
    behind PPP will eventually equalize the
    purchasing power of currencies. This can take
    many years, however. A time horizon of 4-10 years
    would be typical.

43
Parties in International Finance
  • How is PPP calculated? The simplest way to
    calculate purchasing power parity between two
    countries is to compare the price of a "standard"
    good that is in fact identical across countries.
    Eg-price of a McDonald's hamburger around the
    world
  • Problem with PPP Theory
  • One of the key problems is that people in
    different countries consumer very different sets
    of goods and services, making it difficult to
    compare the purchasing power between countries
  • Transportation costs The theory of the law of
    one price assumed that transportation costs were
    negligible and PPP requires the same assumption.
    However, getting products to and from different
    markets can add significant costs to goods
  • Tariffs and Taxes Once again, for PPP to hold,
    another key assumption underlying the law of one
    price is the abstraction of taxes and tariffs.
    There can be no imposition of unequal taxes or
    tariffs in goods imported or exported across
    countries, otherwise this would tend to cause
    further separation of true price levels between
    markets

44
Parties in International Finance
  • Pricing to Market Another contributing factor
    to deviations from PPP is a firms ability to
    mark their products at different price points
    across different markets. Basic business theory
    states that profit maximization can be achieved
    by pricing as high as is appropriate considering
    the elasticity of demand for a product.For
    instance, pharmaceutical companies often charge
    higher prices in the U.S. than in other countries
    for the same exact drug. This is partially
    attributed to higher incomes found in the U.S.
    and the corresponding willingness-to-pay
  • Interest Rate Parity
  • According to interest rate parity the difference
    between the(risk free)interest rates paid on two
    currencies should be equal to the differences
    between the spot and forward rates
  • If interest rate parity is violated, then an
    arbitrage opportunity exists
  • If nominal interest rates are higher in country A
    than country B, the forward rate for country Bs
    currency should be at a premium sufficient to
    prevent arbitrage
  • If IRP holds, arbitrage is not possible it does
    not matter whether you invest in domestic country
    or foreign country, your rate of return will be
    the same as if you invested in home country when
    measured in domestic currency

45
Parties in International Finance
  • If domestic interest rates are less than foreign
    interest rates, foreign currency must trade at a
    forward discount to offset any benefit of higher
    interest rates in foreign country to prevent
    arbitrage
  • If foreign currency does not trade at a forward
    discount or if the forward discount is not large
    enough to offset the interest rate advantage of
    foreign country, arbitrage opportunity exists for
    domestic investors. Domestic investors can
    benefit by investing in the foreign market
  • Covered Interest Rate Parity
  • The principle stating that yields from two
    equivalent investments in the domestic market and
    the foreign market, respectively, are equal after
    accounting for fluctuations in the exchange rate
  • Uncovered Interest Rate Parity
  • A parity condition stating that the difference in
    interest rates between two countries is equal to
    the expected change in exchange rates between the
    countries currencies.
  • For example, assume that the interest rate in
    America is 10 and the interest rate in Canada is
    15. According to the uncovered interest rate
    parity, the Canadian dollar is expected to
    depreciate against the American dollar by
    approximately 5.

46
Parties in International Finance
  • International Fisher effect
  • IFE suggests that given two countries, the
    currency in the country with the higher interest
    rate will depreciate by the amount of the
    interest rate differential
  • For example, if country A's interest rate is 10
    and country B's interest rate is 5, country B's
    currency should appreciate roughly 5 compared to
    country A's currency.
  • Difference between IRP, PPP and IFE-pg99

47
Foreign Trade Policy
  • Duty Entitlement Passbook
  • The objective of DEPB is to neutralise the
    incidence of Customs duty on the import content
    of the export product. The neutralisation shall
    be provided by way of grant of duty credit
    against the export product
  • An exporter may apply for credit, as a specified
    percentage of FOB value of exports, made in
    freely convertible currency
  • The credit shall be available against export
    products at such rates as may be specified by the
    DGFT by way of public notice for import of raw
    materials, intermediates, components etc
  • The DEPB shall be valid for a period of 12 months
    from the date of issue
  • DEPB is transferable and shall be for import at
    the port specified in the DEPB which shall be the
    port from where exports have been made

48
Foreign Trade Policy
  • Export Processing Zones(EPZ)
  • It is an area enjoying special support from GOI
    with respect to fiscal incentives, tax rebates
    and other exclusive benefits for the growth of
    export.
  • No excise duties are payable on goods
    manufactured in these zones provided they are
    made for export purpose
  • Goods being brought in these zones from different
    parts of the country are brought without the
    payment of any excise duty
  • No customs duties are payable on imported raw
    material and components used in the manufacture
    of such goods being exported
  • 50 of production is permitted clearance for
    domestic sale at concessional rate of duty

49
Foreign Trade Policy
  • Export Oriented Units(EOU)
  • The Export Oriented Units (EOUs) scheme is
    complementary to the SEZ scheme. It adopts the
    same production regime but offers a wide option
    in locations with reference to factors like
    source of raw materials, ports of export,
    availability of technological skills, existence
    of an industrial base and the need for a larger
    area of land for the project
  • The main objectives of the EOU scheme is to
    increase exports, earn foreign exchange to the
    country, transfer of latest technologies
    stimulate direct foreign investment and to
    generate additional employment
  • EOU/EPZ Incentives
  • Proposals are granted automatic approvals within
    15 days
  • No import licence is required
  • Exempted from payment of customs duty and excise
    duty
  • 50 of production is permitted clearance for
    domestic sale at concessional rate of duty

50
Foreign Trade Policy
  • Special Economic Zones(SEZ)
  • SEZs are areas where export production can take
    place free from rules and regulations governing
    imports and exports
  • They can import duty free capital goods and raw
    material and the movement of goods to and fro
    between ports and SEZ are unrestricted
  • The units in SEZ have to export the entire
    production
  • Electronic Hardware / Software Technology Parks-
    This scheme is just like EPZ scheme, but it is
    restricted to units in the electronics and
    computer hardware and software sector
  • DFRC(Duty Free Replenishment Certificate)
  • It is issued for the import of inputs used in the
    manufacture of goods without payment of basic
    customs duty
  • It may be issued in respect of exports for which
    payments are received in non-convertible
    currency(The U.S. dollar, Japanese Yen, British
    Pound and EURO are examples of a currency that is
    fully convertible)
  • It shall be issued on minimum value addition of
    25 except for items in gems and jewellery sector

51
Foreign Trade Policy
  • It shall be issued only in respect of products
    covered under the Standard Input Output Norms as
    notified by DGFT(define the amount of inputs
    required to manufacture unit of output for export
    purpose. Input output norms are applicable for
    the products such as electronics, engineering,
    chemical, food products including fish and marine
    products, handicraft, plastic and leather
    products etc)
  • Export Promotion Capital Goods Scheme (EPCG)
  • The scheme allows exporters to import machinery
    both new and second-hand duty free or at
    concessional duty if the importer agrees to
    achieve a fixed export target within a specified
    period of time
  • Currently under the scheme import of capital
    goods carry 10 customs duty though duty free
    imports are also permitted, subject to a minimum
    import volume. Exemptions are available for
    certain sectors like agriculture and garments
    even if the minimum floor limit is not met
  • Duty Exemption/Remission Scheme- It enables duty
    free import of inputs required for export
    production. An advance licence is issued for duty
    free import of inputs. Advance licence can be
    issued for-
  • Physical exports
  • Intermediate supplies

52
Foreign Trade Policy
  • Served from India Scheme- The objective is to
    accelerate the growth in export of services so as
    to create a powerful and unique Served From
    India brand
  • Vishesh Krishi Upaj Yojana- The objective of the
    scheme is to promote export of fruits,
    vegetables, flowers, minor forest produce, and
    their value added products, by incentivising
    exporters of such products
  • Market Development Assistance(MDA)
  • MDA Scheme is intended to provide financial
    assistance for a range of export promotion
    activities implemented by export promotion
    councils, industry and trade associations on a
    regular basis every year. It consists of
  • Market research, commodity research, area survey
    and research
  • Product promotion and commodity development
  • Export publicity and dissemination of information
  • Participation in trade fairs and exhibitions
  • Trade delegations and study teams
  • Establishment of offices and branches in
    countries abroad
  • Grants-in aid to Export Promotion Councils and
    other approved organisations

53
Foreign Trade Policy
  • Market Access Initiative(MAI)- Financial
    assistance is provided for export promotion
    activities on focus country and focus product
    basis. It consists of
  • Market studies/surveys
  • Setting up of showroom/warehouse
  • Participation in international trade fairs
  • Displays in international departmental stores
  • Publicity campaigns
  • Brand promotion

54
Letter of Credit
  • Letters of Credit
  • A letter of Credit is an undertaking by a bank to
    make a payment to a named beneficiary within a
    specified time, against the presentation of
    documents which comply strictly with the terms of
    the LC
  • Parties to a Letter of Credit
  • LC Applicant- LC Applicant is normally the buyer
    under the sales contract and the party that
    initiates the request to the Issuing Bank to
    issue an LC on its behalf. The LC Applicant
    normally maintains banking facilities with
    theIssuing Bank
  • LC Beneficiary- LC Beneficiary is normally the
    seller under the sales contract and the party who
    will receive payment under the LC if it can
    fulfill all the terms and conditions of the
    credit
  • Issuing Bank- An Issuing Bank (or LC opening
    bank) is the bank that issues the LC in favour of
    a seller at the request of the LC applicant
  • Advising Bank- An Advising Bank (or sometimes
    known as notifying bank) is the bank that advises
    the LC beneficiary that there is an LC issued in
    his favour. Advising Bank is normally located in
    the sellers country and is either appointed by
    the Issuing Bank or LC applicant. Its primary
    responsibility is to authenticate the LC to
    ensure that the LC comes from genuine source.

55
Letter of Credit
  • The Flow of Letter of Credit
  • Stage 1 Letter of Credit Issuance and
    Advising/Confirmation
  • Step 1 Buyer and seller conclude the sales
    contract and agreed to use an LC as the method of
    payment.
  • Step 2 Buyer approaches the Issuing Bank to
    issue an LC on his behalf in favour of the seller
    with all the terms and conditions specified.
  • Step 3 Issuing Bank issues the LC and requests
    the advising bank to advise or confirm the credit
    to the LC beneficiary (seller).
  • Step 4 Advising/confirming bank authenticates
    the LC and sends the LC to the LC beneficiary.
  • Stage 2 Presentation of Documents and Settlement
    (Sight LC with Reimbursing Bank)
  • Step 5 Seller prepares and despatches the goods
    to the buyers country.
  • Step 6 Seller presents the documents to the
    nominated bank.
  • Step 7 Nominated Bank checks documents presented
    against the LC terms and conditions and seeks
    instructions from seller on documentary
    discrepancies.

56
Letter of Credit
  • Step 8a Nominated Bank forwards the documents to
    the Issuing Bank.
  • Step 8b If documents are free from
    discrepancies, nominated bank claims
    reimbursement from the appointed reimbursing
    bank.
  • Step 9 Nominated Bank credits the net proceeds
    into the sellers account.
  • Step 10 Issuing Bank checks documents presented
    against the LC terms and conditions. If documents
    are free from discrepancies, Issuing Bank
    reimburses the reimbursing bank.
  • Step 11 Issuing Bank presents documents to the
    buyer for payment.
  • Step 12 Once payment is received from the buyer,
    Issuing Bank releases documents to the buyer for
    the latter to collect his goods.

57
Letter of Credit
  • Types of Letter of Credit
  • Revocable- It can be amended or cancelled at any
    time by the importer without the exporters
    agreement(unless documents have been taken up by
    the nominated bank)
  • Irrevocable- It can neither be amended nor
    cancelled without the agreement of all parties to
    the credit
  • Unconfirmed- It is forwarded by the advising bank
    directly to the exporter without adding its own
    undertaking to make payment or accept
    responsibility to make payment at a future date,
    but confirming its authenticity
  • Confirmed- Advising Bank adds a confirmation that
    payment will be made as long as compliant
    documents are presented
  • Standby Letters of Credit- Standby letters of
    credit are often used in international trade
    transactions, such as the purchase of goods from
    another country. The seller will ask for a
    standby letter of credit, which can be cashed on
    demand if the buyer fails to make payment by the
    date specified in the contract.
  • Revolving Letter of Credit- It is used for
    regular shipments of the same commodity to the
    same importer. Ot avoids the need for repetitious
    arrangements for opening LC

58
Letter of Credit
  • Transferable Letter of Credit- A transferable
    letter of credit is one, which specifically
    states that it is transferable. This will only
    occur if the applicant for the letter of credit
    (buyer) agrees. In a transferable letter of
    credit, the rights and obligations of the
    beneficiary are transferred to another party,
    usually a manufacturer or wholesaler. Transfer
    may be either full or partial
  • Back-to- Back Letter of Credit- Two letters of
    credit (LCs) used together to help a seller
    finance the purchase of equipment or services
    from a subcontractor. With the original LC from
    the buyer's bank in place, the seller goes to his
    own bank and has a second LC issued, with the
    subcontractor as beneficiary. The subcontractor
    is thus ensured of payment upon fulfilling
    the terms of the contract.

59
Letter of Credit
  • Advantages of L/C to Exporters
  • Prevents blocakage of finance
  • Prevents bad debts
  • The L/C is issued after the importer complies
    with the import and exchange control regulations
  • Importer cannot refuse to accept goods
  • An exporter can obtain pre-shipment finance from
    commercial banks on the basis of L/C issued by
    the importers bank in his favour
  • Advantages of L/C to Importers
  • As the payment is assured the importer is in a
    better position to negotiate the terms of trade
  • Importer is assured of the shipment of goods in
    time
  • The importer may also get a L/C issued in favour
    of the exporter on the basis of overdraft
    facility extended to him by the issuing bank. The
    importer gets possession of goods without making
    actual payment
  • No advance payment is required to me made to the
    exporter

60
Managing Foreign Exchange Exposure
  • Foreign Exchange Risk
  • The risk of an investment's value changing due to
    changes in currency exchange rates
  • The risk that an investor will have to close out
    a long or short position in a foreign currency at
    a loss due to an adverse movement in exchange
    rates. Also known as "currenc
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