General Bank Management (CAIIB)

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General Bank Management(CAIIB)

• International Banking (Module A) PART-I
• Foreign Exchange
• Tanushree Mazumdar, IIBF

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Contents of Module A

• Exchange rates
• Risk management and basics of derivatives
• Documentary letters of credit
• Facilities for exporters and importers
• Correspondent banking and NRI accounts
• RBI and exchange control in India, EXIM Bank, ECGC

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Exchange rates

• International transaction in cash requires two
  distinct purchases
• Purchase of foreign currency
• Purchase of good/service with the FC
• Term foreign exchange is used to denote foreign
  currency
• Foreign exchange market exists to cater to the
  demand for foreign currency/currencies

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Foreign Exchange Market

• Organisational setting within which individuals,
  governments and banks buy and sell foreign
  currencies
• Only a small fraction of daily transactions in
  foreign exchange involve trading of currency
• Most foreign exchange transactions involve
  transfer of bank deposits

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Definition of foreign exchange

• 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
• Drafts, travellers cheques, L/Cs, etc. drawn by
  banks, institutions or persons outside India but
  payable in Indian currency
• The above definition is as per FEMA (1999)

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Exchange rate (1)

• Denotes the price or the ratio or the value at
  which one currency is exchanged for another
• Exchange rate is very dynamic
• The foreign exchange market is round-the-clock
  market due to different time zones
• Major participants- central banks, commercial
  banks, forex brokers, corporations, individuals

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Factors affecting exchange rate

• Major banks that act as market-makers always give
  two-way quotes gives depth and volume to the
  market
• Fundamental reasons
• Technical reasons
• Speculation

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Fundamental reasons

• Balance of payments-gtsurplus-gtappreciation
• Growth rate of the economy-gt higher
  growth-gtdepreciation of currency
• Fiscal policy-gt financing of fiscal deficit
  influences exchange rate
• Monetary policy-gtloose monetary policy-gt
  depreciation of exchange rate

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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)

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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
• Acts as a cushion as well- contrarian traders
  exist in the market

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Types of exchange rate (1)

• Ready/cash- Settlement of funds on the same day
  (date of the deal).
• Tom- Settlement of funds takes place on the next
  working day of the date of the deal
• Spot- Settlement of funds takes place on the
  second working day following the date of the deal

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Types of exchange rate (2)

• Forward- Delivery takes place on any day after
  the date of the deal
• In the forex market all rates that are quoted are
  generally spot rates
• When delivery takes place beyond the spot date
  then it is a forward transaction and the forward
  rate is applicable
• Forward rate Spot rate Premium (- discount)

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Forward rate

• If the forward value of a currency is higher than
  the spot value the currency is said to be at a
  premium
• If the above is reversed the currency is said to
  be at a discount
• The forward premium/discount is based on interest
  rate differentials of the two currencies involved
• Direct and indirect quotes of exchange rate-
  direct quote, local currency is variable

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Quotes of Exchange Rate

• Cross rates- To obtain rates for a particular
  currency pair when they are not available
  directly
• Bid and offered rates- In USD/INR 39.40/41 the
  bank is bidding for USD at Rs. 39.40 and offering
  to sell USD at Rs. 39.41

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Exchange Arithmetic

• All foreign exchange calculations have to be
  worked with care and accuracy and several rules
  have to be kept in mind
• Chain rule- is used to attain comparison or ratio
  between two quantities which are linked together
  through another or other quantities. Equation in
  the form of a chain is derived.
• Per cent and per mille- Per 100 units/per 1000
  units

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Example of a Chain Rule (1)

• Query If we have to remit French Francs to
  France from India how do we go about it? (We have
  to arrive at cross rates between FRF and INR.)
• Mumbai interbank market
• US 1 Rs. 41.2550/2650
• London Market
• US 1 FRF 6.0500/6.0550

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Chain rule (2)

• At what rate can one buy FRF against rupees?
• How many Rs----- FRF 1?
• FRF 6.0500 US 1
• US 1 41.2650, therefore,
• FRF 6.0500 US 1 Rs. 41.2650
• Hence, FRF 1 41.2650/6.0500
• Or FRF 1 Rs. 6.8206

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Forward Rate (1)

• Value date It is customary, in foreign exchange
  market, to quote a rate to do the deal but
  exchange the currencies not on the same day but
  generally afterwards.
• Forward rate Has two components
• Spot rate
• Forward points or forward differentials
• Forward rate is the rate when the value of the
  deal is fixed beyond the spot date i.e. beyond
  the second working day after the deal

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Forward Rate (2)

• Forward transactions are necessary in the foreign
  exchange market as they serve number of purposes
  like
• One can hedge or cover an existing future
  financial, commercial or trade related exchange
  risk
• These types of deals, in combination with spot
  deals, are used for money market operations
  through swap transactions
• Taking a view of the market, these can be used
  for speculation

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Forward rate (3)

• When a currency is costlier in the future
  (forward) as compared to the spot, the currency
  is said to be at a premium vis-à-vis another
  currency
• In direct rate premium is added to both the
  buying and selling rate whereas discount is
  deducted
• In indirect rate premium is deducted and
  discount is added to the buying and selling rates

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Forward rate (4)

• Base currency is the currency which is being
  bought and sold and the other currency is
  incidental.
• Forwards are quoted as follows
• Spot/1 month 17/18
• Spot/ 2 months 35/37
• Spot/ 3 months 53/56
• If forward differentials are in the ascending
  order (1st figure is lower than the 2nd) the base
  currency is at premium

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Foreign exchange transactions (1)

• Arbitrage Is an operation by which one can make
  risk free profit by undertaking offsetting
  transactions.
• Can be in interest rates borrow in one centre
  and lend in another
• Can be in exchange rates Buy a currency in one
  market and sell in another
• Arbitrage keeps exchange rates uniform in all
  markets

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Foreign Exchange Transactions (2)

• Merchant rates Quotes offered to merchants
  (importers, exporters) by banks.
• Inter-bank rates The rates quoted by banks for
  dealing in the inter-bank market.
• Merchant quotations In India all merchant
  quotations for foreign currencies shall be in so
  many rupees for one unit of foreign currency
  except for Japanese Yen, Italian Lira and Belgian
  Franc (Rs/100 units of the currency)
• All quotes are in four decimal places with the
  last two digits in the multiple of 25

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Modes of remittances (1)

• Telegraphic Transfers (TT) of funds are done from
  one centre to another by way of instructions
  through telex, telegram or SWIFT (Society for
  Worldwide Interbank Financial Transfer). Of late
  SWIFT is becoming popular
• Mail Transfer (MT) of funds is done by way of
  instructions sent by mail. An MT is an order in
  writing on the correspondent bank/branch abroad
  to pay the beneficiary the sum mentioned

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Modes of Remittances (2)

• Demand draft (DD) A DD is an order in writing on
  the correspondent bank/branch abroad to pay the
  beneficiary the sum mentioned therein.
• Fedai prescribed types of rates of merchant
  transactions
• TT (buying)- clean inward remittances
• Bill (buying)- purchase/discount of export bills
• TT (selling) clean outward remittances
• Bill (selling) remittance for import bills

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RBI/FEDAI Guidelines (1)

• RBI has issued Authorised Dealers (AD) licences
  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 licences to a
  large number of established firms, companies,
  hotels, shops, etc.

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RBI/FEDAI Guidelines (2)

• Money changers help facilitate encashment of
  foreign currencies of foreign tourists
• Entities authorised to buy and sell foreign
  currency notes, coins and travellers cheques are
  called full fledged money changers
• Those authorised only to buy are called
  restricted money changers

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RBI/FEDAI Guidelines (3)

• FEDAI (Foreign Exchange Dealers Association of
  India) is a non-profit making body formed in 1958
  with the approval of RBI
• Its members are authorised dealers and it
  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