Download MBA-IB (International Business) (Master of Business Administration) 4th Semester Forex Management and Currency Derivatives Notes
UNIT - I
Foreign Exchange Markets
A Foreign exchange market is a market in which currencies are bought and
sold. It is to be distinguished from a financial market where currencies are borrowed
and lent.
General Features
Foreign exchange market is described as an OTC (Over the counter) market
as there is no physical place where the participants meet to execute their deals. It is
more an informal arrangement among the banks and brokers operating in a
financing centre purchasing and selling currencies, connected to each other by tele
communications like telex, telephone and a satellite communication network,
SWIFT. The term foreign exchange market is used to refer to the wholesale a
segment of the market, where the dealings take place among the banks. The retail
segment refers to the dealings take place between banks and their customers. The
retail segment refers to the dealings take place between banks and their customers.
The retail segment is situated at a large number of places. They can be considered
not as foreign exchange markets, but as the counters of such markets.
The leading foreign exchange market in India is Mumbai, Calcutta, Chennai
and Delhi is other centers accounting for bulk of the exchange dealings in India.
The policy of Reserve Bank has been to decentralize exchages operations and
develop broader based exchange markets. As a result of the efforts of Reserve Bank
Cochin, Bangalore, Ahmadabad and Goa have emerged as new centre of foreign
exchange market.
Size of the Market
Foreign exchange market is the largest financial market with a daily
turnover of over USD 2 trillion. Foreign exchange markets were primarily
developed to facilitate settlement of debts arising out of international trade. But
these markets have developed on their own so much so that a turnover of about 3
days in the foreign exchange market is equivalent to the magnitude of world trade in
goods and services. The largest foreign exchange market is London followed by
New York, Tokyo, Zurich and Frankfurt.
The business in foreign exchange markets in India has shown a steady
increase as a consequence of increase in the volume of foreign trade of the country,
improvement in the communications systems and greater access to the international
exchange markets. Still the volume of transactions in these markets amounting to
about USD 2 billion per day does not compete favorably with any well developed
foreign exchange market of international repute. The reasons are not far to seek.
Rupee is not an internationally traded currency and is not in great demand. Much of
the external trade of the country is designated in leading currencies of the world,
Viz., US dollar, pound sterling, Euro, Japanese yen and Swiss franc. Incidentally,
these are the currencies that are traded actively in the foreign exchange market in
India.
24 Hours Market
The markets are situated throughout the different time zones of the globe in
such a way that when one market is closing the other is beginning its operations.
Thus at any point of time one market or the other is open. Therefore, it is stated that
foreign exchange market is functioning throughout 24 hours of the day. However, a
specific market will function only during the business hours. Some of the banks
having international network and having centralized control of funds management
may keep their foreign exchange department in the key centre open throughout to
keep up with developments at other centers during their normal working hours
In India, the market is open for the time the banks are open for their regular
banking business. No transactions take place on Saturdays.
Efficiency
Developments in communication have largely contributed to the efficiency
of the market. The participants keep abreast of current happenings by access to such
services like Dow Jones Telerate and Teuter. Any significant development in any
market is almost instantaneously received by the other market situated at a far off
place and thus has global impact. This makes the foreign exchange market very
efficient as if the functioning under one roof.
Currencies Traded
In most markets, US dollar is the vehicle currency, Viz., the currency used
to denominate international transactions. This is despite the fact that with currencies
like Euro and Yen gaining larger share, the share of US dollar in the total turn over
is shrinking.
Physical Markets
In few centers like Paris and Brussels, foreign exchange business takes place
at a fixed place, such as the local stock exchange buildings. At these physical
markets, the banks meet and in the presence of the representative of the central bank
and on the basis of bargains, fix rates for a number of major currencies. This
practice is called fixing. The rates thus fixed are used to execute customer orders
previously placed with the banks. An advantage claimed for this procedure is that
exchange rate for commercial transactions will be market determined, not
influenced by any one bank. However, it is observed that the large banks attending
such meetings with large commercial orders backing up, tend to influence the rates.
Participants
The participants in the foreign exchange market comprise;
(i)
Corporates
(ii)
Commercial banks
(iii)
Exchange brokers
(iv)
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 buy or sell currencies with a view to speculate or trade
in currencies to the extent permitted by the exchange control regulations. They
operate by placing orders with the commercial banks. The deals between banks and
their clients form the retail segment of foreign exchange market.
In India the foreign Exchange Management (Possession and Retention of
Foreign Currency) Regulations, 2000 permits retention, by resident, of foreign
currency up to USD 2,000. Foreign Currency Management (Realisation,
Repatriation and Surrender of Foreign Exchange) Regulations, 2000 requires a
resident in India who receives foreign exchange to surrender it to an authorized
dealer:
(a) Within seven days of receipt in case of receipt by way of remuneration,
settlement of lawful obligations, income on assets held abroad, inheritance,
settlement or gift: and
(b) Within ninety days in all other cases.
Any person who acquires foreign exchange but could not use it for the purpose
or for any other permitted purpose is required to surrender the unutilized foreign
exchange to authorized dealers within sixty days from the date of acquisition. In
case the foreign exchange was acquired for travel abroad, the unspent foreign
exchange should be surrendered within ninety days from the date of return to
India when the foreign exchange is in the form of foreign currency notes and
coins and within 180 days in case of travellers cheques.
Similarly, if a resident required foreign exchange for an approved purpose,
he should obtain from and authorized dealer.
Commercial Banks are the major players in the 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 or 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 constitute hardly 5% of the total transactions done
by a large bank. A major portion of the volume is accounted buy trading in
currencies indulged by the bank to gain from exchange movements. For
transactions involving large volumes, banks may deal directly among
themselves. For smaller transactions, the intermediation of foreign exchange
brokers may be sought.
Exchange brokers facilitate deal between banks. In the absence of exchange
brokers, banks have to contact each other for quotes. If there are 150 banks at a
centre, for obtaining the best quote for a single currency, a dealer may have to
contact 149 banks. Exchange brokers ensure that the most favorable quotation is
obtained and at low cost in terms of time and money. The bank may leave with the
broker the limit up to which and the rate at which it wishes to buy or sell the foreign
currency concerned. From the intends from other banks, the broker will be able to
match the requirements of both. The names of the counter parities are revealed to
the banks only when the deal is acceptable to them. Till then anonymity is
maintained. Exchange brokers tend to specialize in certain exotic currencies, but
they also handle all major currencies.
In India, banks may deal directly or through recognized exchange brokers.
Accredited exchange brokers are permitted to contract exchange business on behalf
of authorized dealers in foreign exchange only upon the understanding that they will
conform to the rates, rules and conditions laid down by the FEDAI. All contracts
must bear the clause subject to the Rules and Regulations of the Foreign
Exchanges Dealers Association of India`.
Central Bank may intervene in the market to influence the exchange rate and
change it from that would result only from private supplies and demands. The
central bank may transact in the market on its own for the above purpose. Or, it may
do so on behalf of the government when it buys or sell bonds and settles other
transactions which may involve foreign exchange payments and receipts.
In India, authorized dealers have recourse to Reserve Bank to sell/buy US
dollars to the extent the latter is prepared to transact in the currency at the given
point of time. Reserve Bank will not ordinarily buy/sell any other currency from/to
authorized dealers. The contract can be entered into on any working day of the
dealing room of Reserve Bank. No transaction is entered into on Saturdays. The
value date for spot as well as forward delivery should be in conformity with the
national and international practice in this regard.
Reserve Bank of India does not enter into the market in the ordinary course,
where the exchages rates are moving in a detrimental way due to speculative forces,
the Reserve Bank may intervene in the market either directly or through the State
Bank of India.
Settlement of Transactions
Foreign exchange markets make extensive use of the latest developments in
telecommunications for transmitting as well settling foreign exchange transaction,
Banks use the exclusive network SWIFT to communicate messages and settle the
transactions at electronic clearing houses such as CHIPS at New York.
SWIFT: SWIFT is a acronym for Society for Worldwide Interbank Financial
Telecommunications, 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 communications network for international financial market transactions linking
effectively more than 25,000 financial institutions throughout the world who have
been allotted bank identified 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 centre through
regional processors in each country. The local banks in each country reach the
regional processors through the national net works.
The SWIFY System enables the member banks to transact among
themselves quickly (i) international payments (ii) Statements (iii) other messages
connected with international banking. Transmission of messages takes place within
seconds, and therefore this method is economical as well as time saving. Selected
banks in India have become members of SWIFT. The regional processing centre is
situated at Mumbai.
The SWIFT provides following advantages for the local banking community:
1. Provides a reliable (time tested) method of sending and receiving messages
from a vast number of banks in a large number of locations around the
world.
2. Reliability and accuracy is further enhanced by the built in authentication
facilities, which has only to be exchanged with each counterparty before
they can be activated or further communications.
3. Message relay is instantaneous enabling the counterparty to respond
immediately, if not prevented by time differences.
4. Access is available t a vast number of banks global for launching new cross
border initiatives.
5. Since communication in SWIFT is to be done using structure formats for
various types of banking transactions, the matter to be conveyed will be very
clear and there will not be any ambiguity of any sort for the received to
revert for clarifications. This is mainly because the formats are used all
ove3r the world on a standardized basis for conducting all types of banking
transactions. This makes the responses and execution very efficient at the
receiving banks end thereby contributing immensely to quality service being
provided to the customers of both banks (sending and receiving).
6. Usage of SWIFT structure formats for message transmission to
counterparties will entail the generation of local banks internal records using
at least minimum level of automation. This will accelerate the local banks
internal automation activities, since the maximum utilization of SWIFT a
significant internal automation level is required.
CHIPS: CHIPS stands for Clearing House Interbank Payment System. It is an
electronic payment system owned by 12 private commercial banks constituting the
New York Clearing House Association. A CHIP began its operations in 1971 and
has grown to be the world`s largest payment system. Foreign exchange and Euro
dollar transactions are settled through CHIPS. It provides the mechanism for
settlement every day of payment and receipts of numerous dollar transactions
among member banks at New York, without the need for physical exchange of
cheques/funds for each such transaction.
The functioning of CHIPS arrangement is explained below with a hypothetical
transaction: Bank of India, maintaining a dollar account with Amex Bank, New
York, sells USD 1 million to Canara Bank, maintaining dollar account with
Citibank.
1. Bank of India intimate Amex Bank debuts the account of Bank through
SWIFT to debit its account and transfer USD 1 million to Citibank for credit
of current account of Canara Bank.
2. Amex Bank debits the account of Bank of India with USD 1 million and
sends the equivalent of electronic cheques to CHIPS for crediting the
account of Citibank. The transfer is effected the same day.
3. Numerous such transactions are reported to CHIPS by member banks and
transfer effected at CHIPS. By about 4.30 p.m, eastern time, the net position
of each member is arrived at and funds made available at Fedwire for use by
the bank concerned by 6.00 p.m. eastern time.
4. Citibank which receives the credit intimates Canara Bank through SWIFT.
It may be noted that settlement of transactions in the New York foreign
exchange market takes place in two stages, First clearance at CHIPS and arriving at
the net position for each bank. Second, transfer of fedfunds for the net position. The
real balances are held by banks only with Federal Reserve Banks (Fedfunds) and
the transaction is complete only when Fedfunds are transferred. CHIPS help in
expediting the reconciliation and reducing the number of entries that pass through
Fedwire.
CHAPS is an arrangement similar to CHIPS that exists in London. CHAPS stands
for Clearing House Automated Payment System.
Fedwire The transactions at New York foreign exchange market ultimately get
settled through Fedwire. It is a communication network that links the computers of
about 7000 banks to the computers of federal Reserve Banks. The fedwire funds
transfer system, operate by the Federal Reserve Bank, 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 effected through banks.
Fed guarantees settlement on all payments sent to receivers even if the sender fails.
TRANSACTIONS IN INTERBANK MARKETS
The exchange rates quoted by banks to their customer are based on the rates
prevalent in the interbank market.
The big banks in the market are known as market makers, as they are willing
to buy or sell foreign currencies at the rates quoted by them up to any extent.
Depending buy or sell foreign currencies at the rates quoted by them up to any
extent. Depending upon its resources, a bank may be a market maker in one or few
major currencies. When a banker approaches the market maker, it would not reveal
its intention to buy or sell the currency. This is done in order to get a fair price from
the market maker.
Two Way Quotations
Typically, the quotation in the interbank market is a two ? way quotation. It
means the rate quoted by the market maker will indicate two prices. One at which it
is willing to buy the foreign currency, and the other at which it is willing to sell the
foreign currency. For example, a Mumbai bank may quote its rate for US dollar as
under
USD 1 = Rs 48.1525/1650
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 quotation,
one rate is Rs.48.1525 per dollar and the other rate is Rs.48.1650. per dollar.
Direct Quotation.
It will be obvious that the quoting bank will be willing to buy dollars at Rs
48.1525 and sell dollars at Rs 48.1650. If one dollar bought and sold, the bank
makes a gross profit of Rs. 0.0125. In a foreign exchange quotation, the foreign
currency is the commodity that is being bought and sold. The exchange quotation
which gives the price for the foreign currency in terms of the domestic currency is
known as direct quotation. In a direct quotation, the quoting bank will apply the
rule: Buy low; Sell high.
Indirect quotation
There is another way of quoting in the foreign exchange market. The
Mumbai bank quotes the rate for dollar as:
Rs. 100 = USD 2.0762/0767
This type of quotation which gives the quantity of foreign currency per unit
of domestic currency is known as indirect quotation. In this case, the quoting bank
will receive USD 2.0767 per Rs.100 while buying dollars and give away USD
2.0762 per Rs.100 while selling dollars. In other world, he will apply the rule: Buy
high: Sell low.
The buying rate is also known as the bid rate and selling rate as the offer`
rate. The difference between these rates is the gross profit for the bank and is known
as the Spread`.
Spot and Forward transactions
The transactions in the interbank market may place for settlement
(a) on the same day; or
(b) two days later; or
(c) some day late; say after a month
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.
The transaction where the exchange of currencies takes place two days after
the date of the contact is known as the spot transaction. For instance, if the
contract is made on Monday, the delivery should take place on Wednesday. If
Wednesday is a holiday, the delivery will take place on the next day, i.e.,
Thursday. Rupee payment is also made on the same day the foreign currency is
received.
The transaction in which the exchange of currencies takes places at a
specified future date, subsequent to the spot date, is known as a forward
transaction. The forward transaction can be for delivery one month or two
months or three months etc. A forward contract for delivery one month means
the exchange of currencies will take place after one month from the date of
contract. A forward contract for delivery two months means the exchange of
currencies will take place after two months and so on.
Forward Margin/Swap points
Forward rate may be the same as the spot rate for the currency. Then it is
said to be at par` with the spot rate. But this rarely happens. More often the forward
rate for a currency may be costlier or chapter tan its spot rate. The rate for a
currency may be costlier or cheaper than nits spot rate. The difference between the
forward rate and the spot rate is known as the forward margin` or swap points. The
forward margin may be either at premium` or at discount`. If the forward margin
is at premium, the foreign correct will be costlier under forward rate than under the
spot rate. If the forward margin is at discount, the foreign currency will be cheaper
for forward delivery then for spot delivery.
Under direct quotation, premium is added to spot rate to arrive at the
forward rate. This is done for both purchase and sale transactions. Discount is
deducted from the spot rate to arrive at the forward rate.
Interpretation of Interbank quotations
The market quotation for a currency consists of the spot rate and the forward
margin. The outright forward rate has to be calculated by loading the forward
margin into the spot rate. For instance, US dollar is quoted as under in the interbank
market on 25th January as under:
Spot
USD 1
=
Rs.48.4000/4200
Spot/February
2000/2100
Spot/March
3500/3600
The following points should be noted in interpreting the above quotation;
1. The first statement is the spot rate for dollars. The quoting bank buying rate
is Rs.48.4000 and selling rate is Rs.48.4200.
2. The second and third statements are forward margins for forward delivery
during the months of February. Spot/March respectively. Spot/February rate
is valid for delivery end February. Spot/March rate is valid for delivery end
March.
3. The margin is expressed in points, i.e., 0.0001 of the currency. Therefore the
forward margin for February is 20 paise and 21 paise.
4. The first rate in the spot quotation is for buying and second for selling the
foreign currency. Correspondingly, in the forward margin, the first rate
relates to buying and the second to selling. Taking Spot/February as an
example, the margin of 20 paise is for purchase and 21 paise is for sale of
foreign currency.
5. Where the forward margin for a month is given in ascending order as in the
quotation above, it indicates that the forward currency is at premium. The
outright forward rates arrived at by adding the forward margin to the spot
rates.
The outright forward rates for dollar can be derived from the above quotations
follows
Buying rate
Selling rate
February
March
February
March
Spot rate
48.4000
48.4000
48.4200
48.4200
Add; Premium
0.2000
0.3500
0.2100
0.3600
--------------- ------------
-------------
48.6000
48.7500
48.6300
48.7800
From the above calculation we arrive at the following outright rates;
Buying
Selling
Spot delivery
USD 1 = Rs. 48.4000
48.4200
Forward delivery February
48.6000
48.6300
Forward delivery March
48.7500
48.7800
If the forward currency is at discount, it would be indicated by quoting the
forward margin in the descending order. Suppose that on 20th April, the quotation
for pound sterling in the interbank market is as follows:
Spot
GBR 1 =
Rs. 73.4000/4300
Spot/May
3800/3600
Spot/June
5700/5400
Since the forward margin is in descending order (3800/3600), forward
sterling is at discount. The outright forward rates are calculated by deducting the
related discount from the spot rate. Thus is shown below:
Buying rate
Selling rate
May
June
May
June
Spot rate
73.4000
73.4000
73.4300
73.4300
Less; discount
0 .
3800
0.5700
0.3600
0.5400
------------
------------
-------------
73.0200
72.8300
73.0700
72.8900
From the above calculations the outright rates for pound sterling cab be
restated as follows;
Buying
Selling
Spot
GBR 1 = Rs. 73.4000
73.4300
Forward delivery May
73.0200
73.0700
Forward delivery June
72.8300
72.8900
Factors Determining Spot Exchange Rates
1. Balance of Payments: Balance of Payments represents the demand for and
supply of foreign exchange which ultimately determine the value of the currency.
Exports, both visible and invisible, represent the supply side for foreign exchange.
Imports, visible and invisible, create demand for foreign exchange. Put differently,
export from the country creates demand for the currency of the country in the
foreign exchange market. The exporters would offer to the market the foreign
currencies they have acquired and demand in exchange the local currency.
Conversely, imports into the country will increase the supply of the currency of the
country in the foreign exchange market.
When the balance of payments of a country is continuously at deficit, it implies
that the demand for the currency of the country is lesser than its supply. Therefore,
its value in the market declines. If the balance of payments is surplus continuously
it shows that the demand for the currency in the exchange market is higher than its
supply therefore the currency gains in value.
(2) Inflation: Inflation in the country would increase the domestic prices of the
commodities. With increase in prices exports may dwindle because the price may
not be competitive. With the decrease in exports the demand for the currency would
also decline; this in turn would result in the decline of external value of the
currency. It may be noted that unit is the relative rate of inflation in the two
countries that cause changes in exchange rates. If, for instance, both India and the
USA experience 10% inflation, the exchange rate between rupee and dollar will
remain the same. If inflation in India is 15% and in the USA it is 10%, the increase
in prices would be higher in India than it is in the USA. Therefore, the rupee will
depreciate in value relative to US dollar.
Empirical studies have shown that inflation has a definite influence on the
exchange rates in the long run. The trend of exchange rates between two currencies
has tended to hover around the basic rate discounted for the inflation factor. The
actual rates have varied from the trend only by a small margin which is acceptable.
However, this is true only where no drastic change in the economy of the country is.
New resources found may upset the trend. Also, in the short run, the rates fluctuate
widely from the trend set by the inflation rate. These fluctuations are accounted for
by causes other than inflation.
(3) Interest rate: The interest rate has a great influence on the short ? term
movement of capital. When the interest rate at a centre rises, it attracts short term
funds from other centers. This would increase the demand for the currency at the
centre and hence its value. Rising of interest rate may be adopted by a country due
to tight money conditions or as a deliberate attempt to attract foreign investment.
Whatever be the intention, the effect of an increase in interest rate is to strengthen
the currency of the country through larger inflow of investment and reduction in the
outflow of investments by the residents of the country.
(4) Money Supply An increase in money supply in the country will affect the
exchange rate through causing inflation in the country. It can also affect the
exchange rate directly.
An increase in money supply in the country relative to its demand will lead
to large scale spending on foreign goods and purchase of foreign investments. Thus
the supply of the currency in the foreign exchange markets is increased and its value
declines. The downward pressure on the external value of the currency then
increases the cost of imports and so adds to inflation.
The effect of money supply on exchange rate directly is more immediate
than its effect through inflation. While in the long run inflation seems to correlate
exchange rate variations in a better way, in the short run exchange rates move more
in sympathy with changes in money supply.
One explanation of how changes in money supply vary the exchange rate is
this; the total money supply in the country represents the value of total commodities
and services in the country. Based on this the outside world determines the external
value of the currency. If the money supply is doubles, the currency will be valued at
half the previous value so as to keep the external value of the total money stock of
the country constant.
Another explanation offered is that the excess money supply flows out of the
country and directly exerts a pressure on the exchange rate. The excess money
created, the extent they are in excess of the domestic demand for money, will flow
out of the country. This will increase the supply of the currency and pull down its
exchange rate.
(5) National Income: An increase in national income reflects increase in the
income of the residents of the country. This increase in the income increases the
demand for goods in the country. If there is underutilized production capacity in the
country, this will lead to increase in production. There is a chance for growth in
exports too. But more often it takes time for the production to adjust to the
increased income. Where the production does not increase in sympathy with income
rise, it leads to increased imports and increased supply of the currency of the
country in the foreign exchange market. The result is similar to that of inflation,
viz., and decline in the value of the currency. Thus an increase in national income
will lead to an increase in investment or in consumption, and accordingly, its effect
on the exchange rate will change. Here again it is the relative increase in national
incomes of the countries concerned that is to be considered and not the absolute
increase.
(6) Resource Discoveries when the country is able to discover key resources, its
currency gains in value. A good example can be the have played by oil in exchange
rates. When the supply of oil from major suppliers, such as Middles East, became
insecure, the demand fro the currencies of countries self sufficient in oil arose.
Previous oil crisis favoured USA, Canada, UK and Norway and adversely affected
the currencies of oil importing countries like Japan and Germany. Similarly,
discovery oil by some countries helped their currencies to gain in value. The
discovery of North Sea oil by Britain helped pound sterling to rise to over USD 2.40
from USD 1.60 in a couple of years. Canadian dollar also benefited from
discoveries of oil and gas off the Canadian East Coast and the Arctic.
(7) Capital Movements there are many factors that influence movement of capital
from one country to another. Short term movement of capital may be influenced
buy the offer of higher interest in a country. If interest rate in a country rises due to
increase in bank rate or otherwise, there will be a flow of short term funds into the
country and the exchange rate of the currency will rise. Reverse will happen in case
of fall in interest rates.
Bright investment climate and political stability may encourage portfolio
investments in the country. This leads to higher demand for the currency and
upward trend in its rate. Poor economic outlook may mean repatriation of the
investments leading to decreased demand and lower exchange value for the
currency of the country.
Movement of capital is also caused by external borrowing and assistance.
Large scale external borrowing will increase the supply of foreign exchange in the
market. This will have a favorable effect on the exchange rate of the currency of the
country. When repatriation of principal and interest starts the rate may be adversely
affected.
(8) Political factors Political stability induced confidence in the investors and
encourages capital inflow into the country. This has the effect of strengthening the
currency of the country. On the other hand, where the political situation in the
country is unstable, it makes the investors withdraw their investments. The outflow
of capital from the country would weaken the currency. Any news about change in
the government or political leadership or about the policies of the government
would also have the effect of temporarily throwing out of gear the smooth
functioning of exchange rate mechanism.
Functions of foreign Exchange Market
The foreign exchange market is a market in which foreign exchange
transactions take place.
Transfer of Purchasing Power
The Primary function of a foreign exchange market is the transfer of
purchasing power from one country to another and from one currency to another.
The international clearing function performed by foreign exchange markets plays a
very important role in facilitating international trade and capital movement.
Provision of credit
The credit function performed by foreign exchange markets also plays a
very important role in the growth of foreign trade, for international trade depends to
a great extent on credit facilities. Exporters may get pre shipment and post shipment
credit. Credit facilities are available also for importers. The Euro dollar market has
emerged as a major international credit market.
Provision of Heding Facilities
The other important of the foreign exchange market is to provide hedging
facilities. Heding refers to covering of foreign trade risks, and it provides a
mechanism to exporters and importers to guard themselves against losses arising
from fluctuations in exchange rates.
Methods of Affecting International Payments
There are important methods to effect international payments.
Transfers
Money may be transferred from a bank in one country to a bank in another
part of the world be electronic or other means
Cheques and Bank Drafts
International payments may be made be means of cheques and bank drafts.
The latter is widely used. A bank draft is a cheque drawn on a bank instead of a
customer`s personal account. It is an acceptable means of payment when the person
tendering is not known, since its value is dependent on the standing of a bank which
is widely known, and not on the credit worthiness of a firm or individual known
only to a limited number of people.
Foreign Bill of Exchange
A bill of exchange is an unconditional order in writing, addressed by one
person to another, requiring the person to whom it is addressed to pay a certain sum
or demand or on a specified future date.
There are two important differences between inland and foreign bills. The
date on which an inland bill is due for payment is calculated from the date on which
it was drawn, but the period of a foreign bill runs fro m the date on which the bill
was accepted. The reason for this is that the interval between a foreign bill being
drawn and its acceptance may be considerable, since it may depend on the time
taken for the bill to pass fro m the drawers country to that of the acceptor. The
second important difference between the two types of bill is that the foreign bill is
generally drawn in sets of three, although only one of them bears a stamp and of
course one of them is paid.
Now days it is mostly the documentary bill that is employed in international
trade. This is nothing more than a bill of exchange with the various shipping
documents the bill of lading, the insurance certificate and the consular invoice
attached to it. By using this the exporter can make the release of the documents
conditional upon either
(a) payment of the bill if it has been drawn at sight or
(b) Its acceptance by the importer if it has been drawn for a period.
Transactions in the foreign Exchange Market
A very brief account of certain important types of transactions conducted in
the foreign exchange market is given below
Spot and Forward Exchanges
Spot Market The term spot exchange refers to the class of foreign exchange
transaction which requires the immediate delivery or exchange of currencies on the
spot. In practice the settlement takes place within two days in most markets. The
rate of exchange effective for the spot transaction is known as the spot rate and the
market for such transactions is known as the spot market.
Forward Market The forward transactions is an agreement between two parties,
requiring the delivery at some specified future date of a specified amount of foreign
currency by one of the parties, against payment in domestic currency be the other
party, at the price agreed upon in the contract. The rate of exchange applicable to
the forward contract is called the forward exchange rate and the market for forward
transactions is known as the forward market.
The foreign exchange regulations of various countries generally regulate the
forward exchange transactions with a view to curbing speculation in the foreign
exchanges market. In India, for example, commercial banks are permitted to offer
forward cover only with respect to genuine export and import transactions.
Forward exchange facilities, obviously, are of immense help to exporters
and importers as they can cover the risks arising out of exchange rate fluctuations
be entering into an appropriate forward exchange contract.
With reference to its relationship with spot rate, the forward rate may be at
par, discount or premium.
If the forward exchange rate quoted is exact equivalent to the spot rate at the
time of making the contract the forward exchange rate is said to be at par.
The forward rate for a currency, say the dollar, is said to be at premium
with respect to the spot rate when one dollar buys more units of another currency,
say rupee, in the forward than in the spot rate on a per annum basis.
The forward rate for a currency, say the dollar, is said to be at discount with
respect to the spot rate when one dollar buys fewer rupees in the forward than in the
spot market. The discount is also usually expressed as a percentage deviation from
the spot rate on a per annum basis.
The forward exchange rate is determined mostly be the demand for and
supply of forward exchange. Naturally when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium and conversely,
when the supply of forward exchange exceeds the demand for it, the rate will be
quoted at discount. When the supply is equivalent to the demand for forward
exchange, the forward rate will tend to be at par.
Futures
While a focus contract is similar to a forward contract, there are several
differences between them. While a forward contract is tailor made for the client be
his international bank, a future contract has standardized features the contract size
and maturity dates are standardized. Futures cab traded only on an organized
exchange and they are traded competitively. Margins are not required in respect of a
forward contract but margins are required of all participants in the futures market an
initial margin must be deposited into a collateral account to establish a futures
position.
Options
While the forward or futures contract protects the purchaser of the contract
fro m the adverse exchange rate movements, it eliminates the possibility of gaining
a windfall profit from favorable exchange rate movement.
An option is a contract or financial instrument that gives holder the right, but
not the obligation, to sell or buy a given quantity of an asset as a specified price at a
specified future date. An option to buy the underlying asset is known as a call
option and an option to sell the underlying asset is known as a put option. Buying or
selling the underlying asset via the option is known as exercising the option. The
stated price paid (or received) is known as the exercise or striking price. The buyer
of an option is known as the long and the seller of an option is known as the writer
of the option, or the short. The price for the option is known as premium.
Types of options: With reference to their exercise characteristics, there are two
types of options, American and European. A European option cab is exercised only
at the maturity or expiration date of the contract, whereas an American option can
be exercised at any time during the contract.
Swap operation
Commercial banks who conduct forward exchange business may resort to a
swap operation to adjust their fund position. The term swap means simultaneous
sale of spot currency for the forward purchase of the same currency or the purchase
of spot for the forward sale of the same currency. The spot is swapped against
forward. Operations consisting of a simultaneous sale or purchase of spot currency
accompanies by a purchase or sale, respectively of the same currency for forward
delivery are technically known as swaps or double deals as the spot currency is
swapped against forward.
Arbitrage
Arbitrage is the simultaneous buying and selling of foreign currencies with
intention of making profits from the difference between the exchange rate
prevailing at the same time in different markets
Forward Contract
Forward contracts are typical OTC derivatives. As the name itself suggests,
forward are transactions involving delivery of an asset or a financial instrument at a
future date. One of the first modern to arrive contracts as forward contracts ere
known was agreed at Chicago Boar of Trade in March 1851 for maize corn to be
delivered in June of that year.
Characteristics of forward contracts
The main characteristics of forward contracts are given below;
They are OTC contracts
Both the buyer and seller are committed to the contract. In other words, they
have to take deliver and deliver respectively, the underlying asset on which
the forward contract was entered into. As such, they do not have the
discretion as regards completion of the contract.
Forwards are price fixing in nature. Both the buyer and seller of a forward
contract are fixed to the price decided upfront.
Due to the above two reasons, the pay off profiles of the borrower and seller,
in a forward contract, are linear to the price of the underlying.
The presence of credit risk in forward contracts makes parties wary of each
other. Consequently forward contracts are entered into between parties who
have good credit standing. Hence forward contracts are not available to the
common man.
Determining Forward Prices
In principle, the forward price for an asset would be equal to the spot or the
case price at the time of the transaction and the cost of carry. The cost of carry
includes all the costs to be incurred for carrying the asset forward in time.
Depending upon the type of asset or commodity, the cost of carry takes into account
the payments and receipts for storage, transport costs, interest payments, dividend
receipts, capital appreciation etc. Thus
Forward price = Spot or the Cash Price + Cost of Carry
Merchant Rate
The foreign exchange dealing of a bank with its customer is known as
merchant business` and the exchange rate at which the transaction takes place is
the merchant rate. The merchant business in which the contract with the customer to
buy or sell foreign exchange is agreed to and executed on the same day is known as
ready transaction or cash transaction. As in the case of interbank transactions a
value next day contract is deliverable on the next business day and a spot contract`
is deliverable on the second succeeding business day following the date of the
contract. Most of the transactions with customers are on ready basis. In practice, the
term ready` and spot` are used synonymously to refer to transactions concluded
and executed on the same day.
Foreign Exchange Transactions
Foreign exchange dealing is a business in which foreign currency is the
commodity. It was seen earlier that foreign currency is not a legal tender. The US
dollar cannot be used for settlement of debts in India; nevertheless, it has value. The
value of US dollar is like the value of any other commodity. Therefore, the foreign
currency can be considered as the commodity in foreign exchange dealings.
Purchase and Sale transactions
Any trading has two aspects (i) Purchase (ii) sale. A trader has to purchase
goods from his suppliers which he sells to his customers. Likewise the bank (which
is authorized to deal in foreign exchange) purchases as well as sells its commodity
the foreign currency.
Two points need be constantly kept in mind while talking of a foreign
exchange transaction:
1. The transaction is always talked of from the banks point of view
2. The item referred to is the foreign currency.
Therefore when we say a purchase we implied that
(i)
the bank has purchased
(ii)
it has purchased foreign currency
Similarly, when we sale a sale, we imply that
(i)
the bank has sold
(ii)
it has sold foreign currency.
In a purchase transaction the bank acquired foreign currency and parts with home
currency.
In a sale transaction the bank parts with foreign currency and acquires home
currency.
Exchange Quotations
We have seen that exchange rates can be quoted in either of the two ways;
(a)direct quotation (b) indirect quotation.
The quotation in which exchange rate is expressed as the price per unit of
foreign currency in terms of the home currency is k known as Home currency
quotation` or Direct quotation`. It may be noted that under direct quotation the
number of units of foreign currency is kept constant and any change in the exchange
rate will be made by changing the value in term of rupees. For instance, US dollar
quoted at Rs.48 may be quoted at Rs 46 or Rs.49 as may be warranted.
The quotation in which the unit of home currency is kept constant and the
exchange rate is expressed as so many unit of foreign currency is known as Foreign
Currency quotation` or Indirect quotation` or simply Currency Quotation`. Under
indirect quotation, any change in exchange rate will be effected by changing the
number of units of foreign currency.
Basis for Merchant Rates
When the bank buys foreign exchange from the customer, it expects to sell
the same in the interbank market at a better rate and thus make a profit out of the
deal. In the interbank market, the bank will accept the rate as dictated by the market.
It can, therefore, sell foreign exchange in the market at the market buying rate for
the currency concerned. Thus the interbank buying rate forms the basis for
quotation of buying rate by the bank to its customer.
Similarly, when the bank sells foreign exchange to the customer, it meets tele
commitment by purchasing the required foreign exchange from the interbank
market. It can acquire foreign exchange from the market at the market selling rate.
Therefore the interbank selling rate forms the basis for quotation of selling rate to
the customer buy the bank.
The interbank rate on the basis of which the bank quotes its merchant rate is
known as the base rate.
Exchange Margin
If the bank quotes the base rate to the customer, it makes no profit. On the
other hand, there are administrative costs involved. Further the deal with the
customer takes p-lace first. Only after acquiring or selling the foreign exchange
from to the customer, the bank goes to the interbank market to sell or acquire the
foreign exchange required to cover the deal with the customer. An hour or two
might have lapsed by this time. The exchange rates are fluctuating constantly and
by the time the deal with the market is concluded, the exchange rate might have
turned adverse to the bank. Therefore sufficient margin should be built into the rate
to cover the administrative cost, cover the exchange fluctuation and provide some
profit on the transaction to the bank. This is done by loading exchange margin to the
base rate. The quantum of margin that is built into the rate is determined by the
bank concerned, keeping with the market trend.
Principal types of Buying Rates
In a purchase transaction the bank acquires foreign exchange from the
customer and pays him in Indian rupees. Some of the purchase transactions result in
the bank acquiring foreign exchange immediately, while some involve delay in the
acquisition of foreign exchange. For instance, if the bank pays a demand drawn on
it by its correspondent bank, there is no delay because the foreign corresponded
bank would already have credited the nostro account of the paying bank while
issuing the demand draft. On the other hand, if the bank purchases on On demand`
bill from the customer, it has first to be sent to the draws place for collection. The
bill will be sent to the correspondent bank for collection. The correspondent bank
will present the bill to the drawee.
Depending upon the tine of realization of foreign exchange by the bank, two
types of buying rates are quoted in India. They are
(i)
TT Buying Rate
(ii)
Bill Buying Rate
(i)TT Buying Rate (TT stands for Telegraphic Transfer)
This is the rate applied when the transaction does not involve any delay in
realization of the foreign exchange by the bank. In other words, the nostro
account of the bank would already have been credited. The rate is calculated by
deducting from the interbank buying rate the exchange margin as determined by
the bank.
Though the name implies telegraphic transfer, it is not necessary that the
proceeds of the transaction are received by telegram. Any transaction where no
delay is involved in the bank acquiring the foreign exchange will be done at the
TT rate.
Transaction where TT rate is applied is;
1. Payment of demand drafts, mail transfers, telegraphic transfers, etc drawn
on the bank where banks nostro account is already credited
2. Foreign bills collected. When a foreign bill is taken for collection, the bank
pays the exporter only when the importer pays for the bill and the banks
nostro account abroad is credited
3. Cancellation of foreign exchange sold earlier. For instance, the purchaser of
a bank draft drawn on New York may later request the bank to cancel the
draft and refund the money to him. In such case, the bank will apply the TT
buying rate to determine the rupee amount payable to the customer.
(ii)Bill Buying Rate
This is the rate to be applied when a foreign bill is purchased. When a bill is
purchased, the rupee equivalent of the bill value is paid to the exporter immediately.
However, the proceeds will be realized by the bank after the bill is presented to the
drawee at the overseas centre. In case pf a usance bill, the proceeds will be realized
on the due date of the bill which includes the transit period and the usance period of
the bill.
Principle types of selling rates
When a bank sells foreign exchange it receives Indian rupees from the
customer and parts with foreign currency. The sale is affected by issuing a payment
instrument on the correspondent bank with which it maintains the nostro account.
immediately on sale, the bank buys the requisite foreign exchange from the market
and gets its nostro account credited with the amount so that when the payment
instrument issued buy its is presented to the corresponded bank it can be honored by
debit to the nostro account. However, depending upon the work involved, viz.,
whether the sale involves handling of documents by the bank or not, two types of
selling rates are quoted in India, they are
1. TT selling rate
2. Bills selling rate
1. TT Selling Rate
This is the rate to be used for all transactions that do not involve handling of
documents by the bank.
Transactions for which this rate is quoted are:
(1) Issue of demand drafts, mail transfers, telegraphic transfer, etc., other
than for retirement of an import bill.
(2) Cancellation of foreign exchange purchased earlier. For instance, when
an export bill purchased earlier is returned unpaid on its due date, the bank will
apply the TT selling rate for the transaction.
2. Bills Selling Rate
This rate is to be used for all transactions which involve handling of
document by the bank: for example, payment against import bills.
The bills selling rate is calculated by adding exchange margin to the TT
selling rate. That means the exchange margin enters into the bills selling rate twice,
once on the interbank rate and again on the TT selling rate.
Ready Rates Based on Cross Rates
The exchange rates for other currencies are quoted to customers based on
the rates for the currency concerned prevailing in international foreign exchange
markets like London, Singapore and Hong Kong. There rates are available in terms
of US dollar. They have to be converted into rupee terms before quoting to the
customers. We shall first examine how exchange rate are quoted in international
markets and then we shall see how these rates are used for quoting rates for
currencies other then US dollar in India.
Exchange quotations in International Markets
In International markets, barring few exceptions, all rates are quoted in term
of US dollar. For instance, at Singapore Swiss franc may be quoted at 1.5425/5440
and Japanese yen at 104.67/70. This should be understood as;
USD 1 = CHF 1.5425 ? 1.5440
USD 1 = JPY 104.67 ? 104.70
In interpreting an international market quotation, we may approach from the
variable currency or the base currency, viz., the dollar. For instance we may take a
transaction in which Swiss franc are received in exchange for dollars as
(a) Purchase of Swiss francs against Dollar
(b) Sale of Dollar against Swiss francs.
The quotation for Swiss franc is CHF 1.5425 and CHF 1.5440 per Dollar. While
buying dollar the quoting bank would part with fewer francs per dollar and while
selling dollars would require as many francs as possible. Thus, CHF 1.5425 is the
dollar buying rate and DEM 1.5440 is the dollar selling rate. It may be observed
that when viewed from dollar, the exchange quotation partakes the character of a
direct quotation and the maxim Buy low: Sell high` is applicable.
Forward Margin/Swap Points.
Dollar/Foreign Currency Quotation
At Singapore market dollar may be quoted against Deutsche mark and
French franc as follows:
Swiss Franc
Japanese
Yen
Spot
1.5425/40
104.67/70
1 month forward
50/60
17/16
2 months forward
70/80
30/29
The forward margin (also called swap margin or swap points) is quoted in
terms of points. A point is the last decimal place in the exchange quotation. Thus in
a four digit quotation, a point is 0.0001. In a two decimal quotation it is 0.01
As against Swiss franc, the forward margin for dollar is CHF 0.0050/0.0060.
Since the order in which the forward margin is ascending, forward dollar is at
premium. Premium is added to the spot rate to arrive at the forward rates, both in
respect of purchase and sale transactions.
Based on the data given above, the forward rates for dollar against Swiss
francs are arrived at as follows;
Dollar
Dollar
Buying
Selling
1 month forward
CHF 1.5475
1.5500
2 months forward
CHF 1.5495
1.5520
Foreign Currency/Dollar Quotation
Let us assume the following exchange rates are prevailing
Pound sterling
Euro
Spot
1.4326/48
0.9525/35
1 month forward
50/53
65/62
2 months forward
90/93
84/82
Against dollar, the forward pound ? sterling is at premium. Premium should
be added to the spot rate to arrive at the forward rate.
Thus the forward rates for pound sterling are as follows.
Pound Sterling
Pound sterling
Buying
Selling
1 month forward
USD 1.4376
1.4401
2 months forward
USD 1.4416
1.4441
Cross Rates and Chain Rule
In India, buying rates are calculated on the assumption that the foreign
exchange acquired is disposed of abroad in the international market and the
proceeds realized in US dollars. The US dollars thus acquired would be sold in the
local interbank market to realize the rupee. For example, if the bank purchased a
CHF 10,000 bill it is assumed that it will sell the Swiss francs at the Singapore
market and acquire US dollars there. The US dollars are then sold in the interbank
market against Indian rupee.
The bank would get the rate for US dollars in terms of Indian rupees in
India. This would be the interbank rate for US dollars. It would also get the rate for
US dollars in terms of Swiss franc at the Singapore market. The bank has to quote
the rate to the customer for Swiss franc in terms of Indian rupees.
The fixing of rate of exchange between the foreign currency and Indian
rupee through the medium of some other currency is done by a method known as
Chain Rule`. The rate thus obtained is the Cross rate` between these currencies.
Role of FEDAI in Foreign Exchange
Authorized Dealers in Foreign Exchange (Ads) have formed an association
called foreign Exchange Dealers Association of India (FEDAI) in order to lay down
certain terms and conditions for transactions in./ Foreign Exchange Business. Ad
has to given an undertaking to Reserve Bank of India to abide by the exchange
control and other terms and conditions introduced by the association for
transactions in foreign exchange business. Accordingly FEDAI has evolved various
rules for various transactions in order to protect the interest of the exporters,
importers general public and also the authorized in dealers. FEDAI which is a
company registered under Section 25 of the companies Act, 1956 has subscribed to
the
1. Uniform customs and practice for documentary credits (UCPDC)
2. Uniform rules for collections(URC)
3. Uniform rules for bank to bank reimbursement.
Various rules of FEDAI
Rules No 1. of FEDAI deals with hours of business of banks which is the normal
banking hours of ADs. On Saturdays no commercial transaction in foreign
exchange will be conducted except purchase/sale of traveler`s cheques and currency
notes and transactions where exchange rates have been already fixed.
Rules No.2 deals with export transactions export bills purchased/discounted
negotiation, export bills for collection export letters of credit, etc.
Application of Rates of Crystallization of Liabilities and Recovers
1. Foreign currency bill will be purchased/ negotiation / discounted at the
Authorized Dealers current bill purchase rate or at the contract rate.
2. Exporters are liable for the repatriation of proceeds of the export bills
negotiated/purchased/discounted sent for collection through the Authorized
Dealers. They would transfer the exchange risk to the exporter by
crystallizing, the foreign currency liability into Rupee liability on the 30th
day after the transit period in case of unpaid demand bills. In case of unpaid
usance bills crystallization will take place on the 30th day after notional due
date or actual due date. Notional due date is arrived at by adding transit
period, usance period and grace period if any to the date of
purchase/discount/negotiation. In case 30th day happens to be a holiday or
Saturday, the export bill will be crystallized on the next working day. For
crystallization into rupee liability the bank will apply the TT selling rate on
the date of crystallization the original buying rate whichever is higher.
Normal Transit period comprises usual time involved from
negotiation/purchase/discount of documents till receipt of proceeds there of
in the Nostro account. It is not, as is commonly misunderstood, the time
taken for the arrival of goods at the destination.
CRYSTALLISATION OF IMPORT BILLS (RULES 30
All foreign currency import bills drawn under letter of credit shall be
crystallized into Rupee liability on the 10th day from the date of c\receipt of
documents at the letter of credit opening bank in the case of demand bills and on the
due date in the case of usance bills. In case the 10th day or due date falls on a
holiday or Saturday the importers liability should be crystallized, into Rupee
liability on the next working day.
INTEREST ON EXPORT BILLS/NORMAL TRANSIT PERIOD
Concessional rate of interest on export bills is linked to the concept of normal
transit period and notional due date. Normal transit period comprised the average
period normally in involved from the date of negotiation/purchase/discount till the
receipt of bill proceeds in the Nostro account of the bank. Normal Transit period is
not to be confused with the time taken for the arrival of goods at the destination.
In case of bills payable at sight` or on demand` basis Concessional rate of
interest ad directed by the RBI on export bill is applicable for the normal transit
period in case of all foreign currency bills.
In case of usance bills, Concessional rate of interest as directed by the RBI on
export bills is applicable for the normal transit period plus usance period. Thus a
foreign currency bill payable for example at 60 days after sight will be eligible for
Concessional interest rate for 60 days usance plus the normal transit period of 25
days, i.e., a total number of 85 days.
Normal Transit period for purpose
Of all bills in foreign Currencies
25 days.
INTEREST ON IMPORT BILLS
a. Bills negotiated under import letter of credit shall carry domestic commercial rate
of interest as applicable to advances prescribed by Reserve Bank of India from time
to time and shall be recovered from the date of debit to the AD`s Nostro account to
the date of crystallization/retirement whichever earlier.
B.From the dates of crystallization up to the date of retirement the bills shall carry
the overdue rate of interest as specified by Reserve Bank of India from time to time.
EXCHANGE CONTRACTS
Exchange contracts shall be for definite amount unless date of delivery is fixed
and indicated in the contract, the option period of delivery should be specified as.
a. The option of delivery shall not exceed beyond, one month. The merchant
whether a buyer or a seller will have the option of delivery.
i.
Early delivery: If a bank accepts or gives early delivery the bank
shall recover/pay swap difference if any.
ii.
Extension: forward contract either short term or long term
contracts where extension is sought by the customers (or as
rolled over) shall be cancelled (at TT selling or buying rate as on
the date of cancellation) and re book only at (current rate of
exchange). The difference between the contracted rate and the
rate at which the contract is cancelled should be recovered
from/paid to be customer at the time of extension. Such request
for the extension should be made on or before the maturity date
of the contract.
iii.
Cancellation: In the case of cancellation of a contract at the
request of the customer, the bank shall recover/pay as the case
may be difference between the contract rate and the rate at which
the cancellation is effected.
b. Rate at which cancellation to be effected.
i.
Purchase contract shall be cancelled at the contracting banks spot
TT selling rate current on the dater of cancellation.
ii.
Sale contracts shall be cancelled at the contracting banks spot TT
buying rate current on the date of cancellation.
iii.
Where the contract is cancelled before maturity the appropriate
TT rate shall be applied.
SWAP Cost:
a. If any shall be recovered from the customers under advise to him.
b.In the absence of any instruction from the customer contracts which have matured
shall on the 15th day from the date of maturity be automatically cancelled. In case
the 15th day falls on a Saturday or holiday the contract will be cancelled on the
succeeding working day.
In the above case the customer will not be entitles to the exchange different
if any since the contract is cancelled on account of his default.
In case of delivery subsequent to automatic cancellation the appropriate
current rate prevailing on such delivery date shall be applied.
Payment of SWAP gains to the customer will normally be made at the end
of the swap period.
Outlay and inflow of funds:
a. Interest at not below the prime lending rate of the respective bank on outlay of
funds by the bank for the purpose of covering the swap shall be recovered in
addition to be swap cost, in case early delivery of purchase or sale contracts and
early realization do export bill negotiated. The amount of funds out laid shall be
arrived at by calculating the difference between the original contracted rate and the
rate at which swap could be arranged.
B. If such a swap leads to inflow of funds the amount shall be paid at the discretion
of banks to the customer at the appropriate rate applicable for the term deposits the
period for which the funds remained with the bank.
C.Banks will levy a minimum charge of Rs.250 for every request from a customer
for early delivery, extension or cancellation of a contract.
Reserve Bank of India Act, 1934
The RBI of India performs both the traditional functions of a central bank
and a variety of developmental and promotional functions. The RBI Act, 1934,
confers upon it the powers to act as not issuing authority, banker`s bank and banker
to the Government.
Reserve Bank as Note Issuing Authority
The Currency of our country consists of one rupee notes and coins
(including subsidiary coins) issued by the Government of India and bank notes
issued by the Reserve Bank. As required by section 38 of the RBI act, Government
puts into circulation one rupee coins and notes through Reserve Bank only. The
Reserve Bank has the sole right to issue bank notes in India. The notes issued by the
Reserve Bank and the one rupee notes and coins issued by the Government are
unlimited legal tender. Reserve Bank also bears the responsibility of exchanging
notes and coins into those of other denominations as required by the public.
As required by the Reserve Bank of India Act, the issue of notes and the
general banking business of the Bank are undertaken by two separate departments
of the Bank. The Issue Department is responsible for the issue of new notes. It
keeps its assets, which form the backing for the note issue, quite separate from the
assets of the Banking Department.
Exchange Control in India
Any transaction in foreign Exchange is governed by Foreign Exchange
Management ACT 1999. The FERA had its origin by defense of India rules (DIR)
1935. This control was exercised in order to ensure the foreign exchange
particularly due to severe constraints on exchange reserve due to Second World
War. Later on 23 March 1947 this rule became in the State Book as Foreign
Exchange Regulation Act 1947. Later this act modified with certain amendments in
1973 and become effective from 01.01.1974. Further relaxation of this affect was
effected since 1994. The same was repealed from 1st June, 2000 and all foreign
exchange transactions from this date will be governed by the provisions of the
Foreign Exchange Management
Act 1999.
As per the foreign exchange Management Act 1999 the Reserve Bank of
India principally controls the movement of the Foreign Exchange of the country. As
per sec 11 (1) of FEMA, the Reserve Bank may for the purpose of securing
compliance with the provisions of this act and any rules, regulations, notification or
directions made there under give to the authorized person any direction in regard to
making of payment or the doing or desist from doing any act relating to foreign
security.
As per Section 11(2) of the act the Reserve Bank may for the purpose of
ensuring the compliance with the provisions of the Act or of any rules regulations
notification or order made there under direct any authorized person to furnish such
information in such manners as it deem fit.
As per Section 11 (3) where any authorized person contravenes any
direction given by the Reserve Bank under this act or fail to file any return as
directed by the Reserve Bank, the Reserve Bank may after giving reasonable
opportunities of being heard impose on the authorized person a penalty which may
extent to ten thousand rupees and in the case of continuing contravention with an
additional penalty which may extend to two thousand rupees for every day during
which such contravention continues.
The Exchange control Manual published by Reserve Bank if India gives
various directives to authorized dealers in foreign exchange. The authorized dealers
in foreign exchange are expected to strictly follow the directives of RBI in
exchange control manual without any deviation.
UNIT-II
Lesson 1: Exchange Rates ? Exchange rate systems ? Gold Standard ? Bretton
Woods - Fixed Vs Floating Exchange Rate systems
Objectives:
After studying this lesson you should be able
To understand various monetary systems have been in practice from time to
time.
To know about gold standard and its implications in international monetary
environment.
To know about Bretton Woods system and its implications in international
monetary environment.
To know the differences between fixed and floating exchange rate systems.
Structure
1.1 Introduction
1.2 Exchange Rate Systems
1.3. Gold Standard
1.4 Bretton Woods
1.5 Fixed Vs Floating Exchange Rate Systems
1.6 Summary
1.7 Glossary
1.8 Self Assessment Questions
1.9 Further Readings
1.1 Introduction:
The increased volatility of exchange rates is one of the main economic
developments of recent past. Under the current system of partly floating and partly
fixed exchange rates, the earnings of multinational firms, banks, and individual
investors have been subjected to significant real and paper fluctuations as a result of
changes in relative exchange rates. Although volatile exchange rates may increase
risk, they also create profit opportunities for both firms and investors, given a
proper understanding of exchange risk management. The international monetary
system can be defined as the structure within which foreign exchange rates are
determined, international trade and capital flows are accommodated, and balance of
payments adjustments made. It also includes all the instruments, institutions, and
agreements that link together the world`s currency, money markets, securities, real
estate and commodity markets.
1.2. Exchange Rate Systems
Over the ages, currencies have been defined in terms of gold and other items of
value, and the international monetary system has been subject to a variety of
international agreements. A brief history of these systems provides useful
perspective against which to compare today`s system and to evaluate weaknesses
and proposed changes in the present system. In the following sections various
monetary standards that were in practice since 19th century were briefly explained.
The international monetary system has evolved historically from the gold standard
(1876-1913) of fixed exchange rates, to the interwar years and World War II (1914-
1944) with floating exchange rates, to fixed exchange rates (1945-1973) under the
Bretton Woods Agreement, to the present eclectic currency arrangement (1973-
present) of fixed, floating, and managed exchange rates. In the following sections
an attempt has been made to explain them briefly for understanding of their
significance in international monetary environment.
1.3. The Gold Standard (1876 ? 1913):
A system of setting currency values whereby the participating countries commit to
fix the prices of their domestic currencies in terms of a specified amount of gold.
The gold standard as an international monetary system gained acceptance in
Western Europe in the 1870s. The United States was something of a latecomer to
the system, not officially adopting the standard until 1879.
The rules of the game under the gold standard were clear and simple. Each
country set the rate at which its currency (paper or coin) could be converted to a
weight of gold. The United States, for example, declared the dollar to be convertible
to gold at a rate of $20.67/ounce of gold (a rate in effect until the beginning of
World War 1). The British pound was pegged at ?4.2474/ounce of gold. As long as
both currencies were freely convertible into gold, the dollar/pound exchange rate
was:
$20.67/ounce of gold
= $4.8665/?
?4.2474/ounce of gold
Because the government of each country on the gold standard agreed to buy or sell
gold on demand to anyone at its own fixed parity rate, the value of each individual
currency in terms of gold, and therefore the fixed parities between currencies, was
set. Under this system it was very important for a country to maintain adequate
reserves of gold to back its currency`s value. The system also had the effect of
implicitly limiting the rate at which any individual country could expand its money
supply. The growth in money was limited to the rate at which additional gold could
be acquired by official authorities. The gold standard worked adequately until the
outbreak of World War 1 interrupted trade flows and the free movement of gold.
This caused the main trading nations to suspend the operation of the gold standard.
1.3.1. Advantages of Gold Standard:
Several advantages are claimed for the gold standard, especially when it is adopted
simultaneously by a number of countries, i.e., international gold standard.
(i)
It is an objective system and is not subject to the changing policies of
the government or the whims of the currency authority.
(ii)
Gold standard enables the country to maintain the purchasing power
of its currency over long periods. This is so because the currency and credit
structure is ultimately based on gold in possession of the currency authority.
(iii)
Another important advantage claimed for gold standard is that it
preserves and maintains the external value of the currency (rate of
exchange) within narrow limits. As a matter of fact, within the gold
standard system, it provides fixed exchanges, which is a great boon to
traders and investors. International division of labour is greatly facilitated.
(iv)
It gives, in fact, all the advantages of a common international
currency. It establishes an international measure of value. As Marshall
pointed out before the Fowler Committee (Report on Indian Currency) in
1898, the change to a gold basis is like a movement towards bringing the
railway gauge on the side branches of the world`s railway into unison with
the main lines. This greatly facilitates foreign trade, because fluctuations in
rates of exchange hamper international trade.
(v)
It is further claimed that gold standard helps to adjust the balance of
payments between countries automatically. How this happens may be
illustrated by a simple example. Suppose England and America are both on
gold standard and only trade with each other, and that a balance of payments
is due from England to America. Gold will be exported from England to
America. The Bank of England will lose gold. This will contract currency
in England and bring about a fall in the British price level. Price level in
America will rise due to larger reserves and the expansion of currency and
credit. England will become a good market to buy from and a bad market to
sell in. Conversely, America will become a good market to sell in and a bad
market to buy from. British exports will be encouraged and imports
discouraged. American exports will be discouraged and imports
encouraged. The balance of payments will tend to move in favour of Britain
until equilibrium is reached. It is in this way, that movement of gold, by
affecting prices and trade, keeps equilibrium among gold standard countries.
1.3.2. Disadvantages of Gold Standard:
(i)
Gold standard is costly and the cost is unnecessary. We only want a
medium of exchange, why should it be made of gold? It is a luxury. The
yellow metal could tickle the fancy of savages only.
(ii)
Even the value of gold has not been found to be absolutely stable over
long periods.
(iii)
Under the gold standard, currency cannot be expanded in response to the
requirements of trade. The supply of currency depends on the supply of
gold. But the supply of gold depends on the success of the mining
operations, which may have nothing to do with the factors affecting the
growth of trade and industry in the country.
(iv)
Gold standard has also been charged with sacrificing internal stability to
external (exchange) stability. It is the international aspect of the gold
standard which has been paid more attention to.
(v)
Another disadvantage is that, under gold standard gold movements lead
to changes in interest rates, so that investment is stimulated or checked
solely in order to expand or reduce money income.
(vi)
A country on a gold standard cannot follow an independent policy. In
order to maintain the gold standard or to restore it (as in England after
World War I), it may have to deflate its currency against its will. Deflation
spells ruin to the economy of a country. It brings, in its wake, large-scale
unemployment, closing of works and untold suffering attendant on
depression.
1.3.3. Causes of the Break-down of the Gold Standard
The gold standard broke down in country after country soon after its rehabilitation
during the post-1914-18 war decade. There were several reasons for this
development:
(1) Gold was very unevenly distributed among the countries in the inter-war period.
While the U.S.A. and France came to possess the bulk of it, other countries did
not have enough to maintain a monetary system based in gold.
(2) Owing to general political unsettlement, a habit arose on the part of certain
Continental countries to keep their funds for short periods in foreign central
banks, especially in Great Britain. These funds were liable to be withdrawn at
the earliest danger signal. Withdrawal of such funds from Britain on the part of
France led to gold standard being suspended in 1931 in the former country. The
Bank of England could not afford to lose its gold resources in large quantities at
such a short notice.
(3) International trade was not free. Some countries often imposed stringent
restrictions on imports, which created serious balance of payments problems for
other countries. Not having enough gold to cover the gap, they threw the gold
standard overboard. This specially happened during the Great Depression of
early thirties.
(4) International obligation in the form of reparations and war debts arose out of
World War I. Since the creditor countries refused to accept payments in the
form of goods and also refused to continue lending to the debtors countries, the
debts had to be cleared through gold movements. This led to concentration of
34 per cent of the world`s gold in the U.S.A. and France, the two chief creditor
countries. The gold left with the other countries was not enough to enable them
to maintain gold standard successfully.
(5) The gold-receiving countries did not play the game of the gold standard.
They (especially the U.S.A.) did not allow this gold to have any effect on their
price levels. The gold was sterilised or made ineffective. Had prices risen in
these countries, imports would have been encouraged and exports discouraged
and an unfavourable balance of trade would have led to movement of gold in the
reverse direction. Since this was not allowed to happen, the gold standard failed
to work automatically.
(6) Gold standard failed also because the economic structure of the countries
concerned had become less and less elastic after the World War of 1914-18.
This was due to several reasons: The enormous growth in the indebtedness of
governments and local authorities resulted in a mass of interest payments fixed
by contract over a long period of years. The huge expenditure in the form of
payment to social services could not be easily reduced. The trade unions were
now able to offer a much stronger resistance to wage cuts than before 1914.
The prices of raw materials and finished goods were becoming more and more
fixed by partial monopolies, cartel agreements, etc. The result was that prices
no longer moved in the directions warranted by gold movements and
equilibrium failed to be restored as of old.
(7) Another weakness that was discovered in the gold standard in practice was that
it was always liable to collapse in a crisis. It has often been called a fair
weather standard` only.
(8) Another objection that was frequently urged against the system was that gold
movements caused inconvenient changes in interest rates. Deflation, for
instance, may be made necessary at a time of crisis to prevent suspension of the
standard. But deflation, which involves falling wages and prices, may prove a
cause of serious trouble. Wage cuts are resisted by trade unions, and falling
prices increase the burden of fixed payments which the government or the
people may have to make. Moreover, falling prices discourage enterprise and
create unemployment.
A large volume of short-term capital was moving for safely from one financial
centre to another. Big flows of this hot money necessitated large gold movements,
which the slender gold reserves of the countries could not maintain. Hence, gold
standard was given up. Thus, it was that country after country abandoned the Gold
Standard in the inter-war period (1914-1944).
1.4. Bretton Woods (1944):
In 1944, as World War II drew toward a close, the Allied Powers met at Bretton
Woods, New Hampshire, in order to create a new post-war international monetary
system. The Bretton Woods Agreement, implemented in 1946, whereby each
member government pledged to maintain a fixed, or pegged, exchange rate for its
currency vis-?-vis the dollar or gold. These fixed exchange rates were supposed to
reduce the riskiness of international transactions, thus promoting growth in world
trade. The Bretton Woods Agreement established a US dollar-based international
monetary system and provide for two new institutions, The IMF and the World
Bank. The IMF aids countries with balance of payments and exchange rate
problems. The International Bank for Reconstruction and Development (World
Bank) helped post-war reconstruction and since then has supported general
economic development.
The IMF was the key institution in the new international monetary system, and it
has remained so to the present. The IMF was established to render temporary
assistance to member countries trying to defend their currencies against cyclical,
seasonal, or random occurrences. It also assists countries having structural trade
problems if they take adequate steps to correct their problems. However, if
persistence deficits occur, the IMF cannot save a country from eventual
devaluation. In recent years it has attempted to help countries facing financial
crises. It has provided massive loans as well as advice to Russia and other former
Russian republics, Brazil, Indonesia, and South Korea, to name but a few.
Under the original provisions of the Bretton Woods Agreement, all countries fixed
the value of their currencies for gold. Only the dollar remained convertible into
gold (at $35 per ounce). Therefore, each country decided what it wished its
exchange rate to be vis-?-vis the dollar and then calculated the gold per value of its
currency to create the desired dollar exchange rate. Participating countries agreed
to try to maintain the value of their currencies within 1% (later expanded to 2 ? %)
of par by buying or selling foreign exchange or gold as needed. Devaluation was
not to be used as a competitive trade policy, but if a currency became too weak to
defend, a devaluation of up to 10% was allowed without formal approval by the
IMF. Larger devaluations required IMF approval.
1.4.1. The Special Drawing Rights (SDRs):
The Bretton Woods also known as IMF system was an improvement on the gold
standard. The IMF system had all the merits of the gold standard minus its
demerits. It ensured exchange stability without the country having to undergo the
expense of maintaining a costly currency system. Under the IMF system, exchange
parities were fixed in gold but it was unnecessary to keep large gold reserves for
currency purposes. Besides gold stocks and current output were utterly inadequate
to meet the requirements of over-expanding volume of international trade, thus
giving rise to the serious problem of international liquidity. The IMF sought to
provide multilaterism. The IMF quota facilitated foreign exchange transactions and
there was no need to export gold to meet a trade deficit. It also facilitated
convertibility of currencies and provided adequate and convenient currency reserve
for the use of member countries. However, fast changing circumstances are
necessitated changes in the IMF system. In September 1967, the Board of
Governors approved a plan for a new type of international asset known as the SDRs
(Special Drawing Rights).
SDRs is an international reserve asset created by the IMF to supplement existing
foreign exchange reserves. It serves as a unit of account for the IMF and other
international and regional organizations, and it is also the base against which some
countries peg the rate of exchange for their currencies. Defined initially in terms of
a fixed quantity of gold, the SDR has been redefined several times. It is currently
the weighted value of currencies of the five IMF members having the largest
exports of goods and services. Individual countries hold SDRs in the form of
deposits in the IMF. These holdings are part of each country`s international
monetary reserves, along with official holdings of gold, foreign exchange, and its
reserve position at the IMF. Members may settle transactions among themselves by
transferring SDRs.
Under the Scheme, the IMF is empowered to allocate to various member countries
SDR`s on a specified basis, which in effect amounts to raising the limit to which a
member country can draw from the IMF in time of need. Besides, the SDR`s
supplement gold, dollars and pounds sterling most countries use as monetary
reserves. They can be used unconditionally by the participating countries to meet
their liabilities and they are not backed by gold. They are meant to be used by the
Central banks of the Fund`s member countries. With the SDR`s, the Central banks
can buy whatever currencies they need for settling their balance of payments
deficits. The resources of the new scheme are not a pool of currencies but simply
the obligation of participating members to accept the SDR`s for settlement of
payments between them. Thus, SDR`s serve as an international money as good as
other reserve currencies.
But a nicely and diligently built up system of exchange stability by the IMF
collapsed like a house of cards. This was caused by the dollar crisis created by the
adverse American balance of payments. Among the measures taken by the
American administration, there was one which delinked dollar from gold. The
delinking of dollar from gold knocked out the very foundation of the IMF. In
January 1975, the IMF abolished the official price of gold and SDR`s have instead
become the basis of the present international monetary standard. The SDR`s are not
convertible into gold; that is why alternatively the present standard may also be
referred to as Paper Gold Standard.
1.5 Fixed Vs Floating Exchange Rate Systems:
1.5.1. Fixed Exchange Rates, 1945-1973
The currency arrangement negotiated at Bretton Woods and monitored by the IMF
worked fairly well during the post-World War II period of reconstruction and rapid
growth in world trade. However, widely diverging national monetary and fiscal
policies, differential rates of inflation, and various unexpected external shocks
eventually resulted in the system`s demise. The U.S. dollar was the main reserve
currency held by central banks and was the key to the web of exchange rate values.
Unfortunately, the United States ran persistent and growing deficits on its balance
of payments. A heavy capital outflow of dollars was required to finance these
deficits and to meet the growing demand for dollars from investors and businesses.
Eventually, the heavy overhang of dollars held abroad resulted in a lack of
confidence in the ability of the United States to meet its commitment to convert
dollars to gold.
On August 15, 1971, President Richard Nixon was forced to suspend official
purchases or sales of gold by the U.S. Treasury after the United States suffered
outflows of roughly one-third of its official gold reserves in the first seven months
of the year. Exchange rates of most of the leading trading countries were allowed to
float in relation to the dollar and thus indirectly in relation to gold. By the end of
1971 most of the major trading currencies had appreciated vis-?-vis the dollar. This
change was ? in effect ? a devaluation of the dollar.
In early 1973, the U.S. dollar came under attack once again, thereby forcing a
second devaluation on February 12, 1973, this time by 10% to $42.22 per ounce.
By late February 1973, a fixed ?rate system no longer appeared feasible given the
speculative flows of currencies. The major foreign exchange makets were actually
closed for several weeks in March 1973. When they reopened, most currencies
were allowed to float to levels determined by market forces. Par values were left
unchanged. The dollar had floated downward an average of 10% by June 1973.
1.5.2. An Eclectic Currency Arrangement, 1973-Present
Since March 1973, exchange rates have become much more volatile and less
predictable than they were during the fixed exchange rate period, when changes
occurred infrequently. In general the dollar has been volatile and has weakened
somewhat over the long run. On the other hand, the Japanese yen and German
mark have strengthened. The emerging market currencies have been exceptionally
volatile and have generally weakened.
In the wake of the collapse of the Bretton Woods exchange rate system, the IMF
appointed the Committee of Twenty which suggested various options for the
exchange rate arrangement. These suggestions were approved at Jamaica during
February 1976 and were formally incorporated into the text of the Second
Amendment to the Articles of Agreement, which came into force from April 1978.
The options were broadly:
1. Floating-independent and managed
2. Pegging of currency
3. Crawling peg
4. Target zone arrangement
5. Others
1. Floating Rate System: In a floating-rate system, it is the market forces that
determine the exchange rate between two currencies. The advocates of the
floating rate system put forth two major arguments. One is that the exchange
rate varies automatically according to the changes in the macroeconomic
variables. As a result, there is no gap between the real exchange rate and the
nominal exchange rate. The country does not need any adjustment, which is
often required in a fixed rate regime and so it does not have to bear the cost of
adjustment. The other argument is that this system possesses insulation
properties, meaning that the currency remains isolated from the shocks
emanating from other counties. It also means that the government can adopt an
independent economic policy without impinging upon the external sector
performance.
In case of Managed Floating with no preannounced path for the exchange rate,
the monetary authority influences the movements of the exchange rate through
active intervention in the foreign exchange market without specifying, or pre-
commiting to, a pre-announced path for the exchange rate. In case of
Independent Floating, the exchange rate is market-determined, with any foreign
exchange intervention aimed at moderating the rate of change and preventing
undue fluctuations in the exchange rate, rather than at establishing a level for it.
2. Pegging of Currency: Normally, a developing country pegs its currency to a
strong currency or to a currency with which it conducts a very large part of its trade.
Pegging involves fixed exchange rate with the result that trade payments are stable.
But in case of trading with other countries, stability cannot be guaranteed. This is
why pegging to a single currency is not advised if the country`s trade is diversified.
In such cases, pegging to a basket of currencies is advised. But if the basket is very
large, multi-currency intervention may prove costly. Pegging to SDR is not
different insofar as the value of the SDR itself is pegged to a basket of five
currencies.
3. Crawling Peg: Again, a few countries have a system of a crawling peg. Under
this system, they allow the peg to change gradually over time to catch up with
changes in the market-determined rates. It is a hybrid of fixed-rate and flexible rate
systems. So this system avoids too much of instability and too much of rigidity. In
some of the countries opting for the crawling peg, crawling bands are maintained
within which the value of currency is maintained. The currency is adjusted
periodically in small amounts at a fixed, preannounced rate or in response to
changes in selective quantitative indicators.
4. Target Zone Arrangement: In a target zone arrangement, the intra-zone
exchange rates are fixed. An apposite example of such an arrangement was found
in European Monetary Union (EMU) before coming in of Euro. However, there are
cases where the member countries of a currency union do not have their own
currency, rather they have a common currency. Under this group, come the
member countries of the Eastern Caribbean Currency Union, the Western African
Economic and Monetary Union, and the Central African Economic and Monetary
Community. The member countries of the European Monetary Union too came
under this group with the Euro substituting their currency in 2002.
5. Others: Apart from the models discussed above there do different countries
follow some more practices. They are:
a) Currency Board Arrangements: A monetary regime based on an implicit
legislative commitment to exchange domestic currency for a specified foreign
currency at a fixed exchange rate, combined with restrictions on the issuing
authority to ensure the fulfillment of its legal obligation.
b) Dollarization: Several countries that have suffered for many years from
currency devaluation, primarily as a result of inflation, have taken steps towards
dollarization, the use of the U.S. dollar as the official currency of the country.
1.5.3. Fixed versus Flexible Exchange Rates:
A nation`s choice as to which currency regime it follows reflects national priorities
about all facets of the macro economy, including inflation, unemployment, interest
rate levels, trade balances, and economic growth. The choice between fixed and
flexible rates may then change as priorities change. At the risk of
overgeneralization, the following observations explain why countries pursue certain
exchange rate regimes. They are based on the premise that, other things being
equal, countries would prefer fixed exchange rates.
1. Fixed rates provide stability in international prices for the conduct of trade.
Stable prices aid in the growth of international trade and lessen risks for all
businesses.
2. Fixed exchange rates are inherently anti-inflationary, requiring the country to
follow restrictive monetary and fiscal policies. This restrictiveness, however,
can often be a burden to a country wishing to pursue policies that alleviate
continuing internal economic problems, such as high unemployment or slow
economic growth.
3. Fixed exchange rate regimes necessitate that central banks maintain large
quantities of international reserves (hard currencies and gold) to be used in the
occasional defense of their fixed rate. As the international currency markets
have grown rapidly in size and volume, this need has become a significant
burden to many nations.
4. Fixed rates, once in place, may be maintained at rates that are inconsistent with
economic fundamentals. As the structure of a nation`s economy changes, and as
trade relationships and balances evolve, the exchange rate itself should change.
Flexible exchange rates allow this change to happen gradually and efficiently,
but fixed rates must be changed administratively-usually too late, with too much
publicity, and at too great a one-time cost to the nation`s economic health.
1.5.3.1. Global Scenario of Exchange Rate Arrangements:
Firms engaged in international business must have an idea bout the exchange rate
arrangement prevailing in different countries as this will facilitate their financial
decisions. In this context, it can be said that over a couple of decades, the choice of
the member countries has been found shifting from one form of exchange rate
arrangement to the other, but, on the whole, preference for the floating rate regime
is quite evident. At present as many as 35 of a total of 187 countries have an
independent float, while the other 51 countries have managed floating system. The
other 7 countries have a crawling peg, while 53 countries have pegs of different
kinds. The EMU and other 20 countries of Africa and the Caribbean region come
under some kind of economic and monetary integration scheme in which they have
a common currency. Lastly, nine countries do not have their own currency as legal
tender.
The recent developments in the field of international monetary environment are
worth mentioning. They are launch of Euro as the single currency for 11 of
European countries and the currency crises in emerging markets. They are briefly
mentioned below:
a) The Launch of Euro: On January 1, 1999, 11 member states of the EU initiated
the European Monetary Union. They established a single currency, the Euro, which
replaced the individual currencies of the participating member states. On December
31, 1998, the final fixed rates between the 11 participating currencies and the Euro
were put into place. On January 4, 1999, the Euro was officially traded. The 15
members of the European Union are also members of the European Monetary
System. According to the EU, EMU is a single currency area, now known
informally as the Euro Zone, within the EU single market in which people, goods,
services and capital move without restrictions. In December 1991, the members of
the European Union met at Maastricht, the Netherlands and concluded a treaty that
changed Europe`s currency future. The Maastricht Treaty specified a timetable and
a plan to replace all individual currencies with a single currency, now called the
Euro. Other steps were adopted that would lead to a full European Economic and
Monetary Union. The growth of global markets and the increasing competitiveness
of the Americas and Asia drove the members of the EU in the 1980s and 1990s to
take actions that would allow their residents and their firms to compete globally.
The reduction of barriers across all members countries to allow economies of scale
(size and cost per unit) and scope (horizontal and vertical integration) was thought
to be Europe`s only hope of not being left behind in the new millennium. The
successful implementation of a single, strong, and dependable currency for the
conduct of life could well alter the traditional dominance of the U.S. dollar as the
world`s currency.
b) Emerging Market Crises: After a number of years of relative global economic
tranquility, the second half of the 1990s was racked by a series of currency crises
that shook all emerging markets. The devaluation of the Mexican peso in
December 1994 served as a harbinger of crises to come. The Asian crisis of July
1997, the Russian ruble`s collapse in August 1998, and more recently the fall of the
Brazilian real in January 1999 provide a spectrum of emerging market economic
failures, each with its own complex causes and unknown outlooks. These crises
also illustrate the growing problem of capital flight and short-run international
speculation in currency and securities markets.
The Asian crisis of 1997. The roots of the Asian currency crisis extended from
a fundamental change in the economics of the region, the transition of many
Asian nations from net exporters to net importers. The most visible roots of the
crisis were in the excesses of capital flows into Thailand in 1996 and early
1997. As the investment bubble expanded, some participants raised questions
about the economy`s ability to repay the rising debt. The bath came under
sudden and severe pressure. The Asian crisis ? for it was more than just a
currency collapse- had many roots besides the traditional balance-of-payments
difficulties. The complex structures combining government , society, and
business throughout the Far East provide a backdrop for understanding the
tenuous linkage between business, government, and society.
The Russian crisis of 1998. The loss of the relatively stable ruble, once
considered the cornerstone and symbol of success of President Boris Yeltsin`s
regime, was a potential death blow to the current Russian government and
economic system. If nothing else, Russian borrowers may find themselves
persona non grata for years to come in the international capital markets.
The Brazilian crisis of 1999. Potentially the mildest of the three currency
collapses, the Brazilian real`s fall in January 1999 was the result of a long
expected correction in an ill-conceived currency policy. Because so many
major Brazilian firms are publicly traded, this crisis serves as an excellent
example of how equity markets revalue firms that are exposed to currency
devaluations and vice versa.
1.5.4. Attributes of the Ideal Currency:
If the ideal currency existed in today`s world, it would possess three attributes:
Fixed value. The value of the currency would be fixed in relationship to other
major currencies so that trades and investors could be relatively certain of the
foreign exchange value of each currency in the present and into the near future.
Convertibility. Complete freedom of monetary flows would be allowed, so
that traders and investors could willingly and easily move funds from one
country and currency to another in response to perceived economic
opportunities or risks.
Independent monetary policy. Domestic monetary and interest rate policies
would be set by each individual country so as to pursue desired national
economic policies, especially as they might relate to limiting inflation,
combating recessions, and fostering prosperity and full employment.
Unfortunately, these three attributes usually cannot be achieved at the same
time. For example, countries whose currencies are pegged to each other are in
effect agreeing to both a common inflation rate and a common interest rate
policy. If inflation rates differ but the peg (i.e., fixed exchange rate) is
maintained, one country`s goods become cheaper in the other countries. This
will lead to unemployment in the high-inflation country. If one country`s
interest rates are higher than the others and the peg is maintained, investors will
move funds from the low-rate country to the high-rate country, creating ever
more difficulty in maintaining the peg.
1.5.4.1. Essentials of a Sound Currency System:
Broadly speaking, a sound currency system must fulfil the following conditions:
(i)
It must maintain a reasonable stability of prices in the country. This
means that its internal value (or purchasing power in terms of goods and
services in the country concerned) must not fluctuate too violently. This
involves regulation of the amount of money in circulation to suit the
requirements of trade and industry in the country.
(ii)
A sound currency system must maintain stability of the external
value of the currency. This means that its purchasing power over goods and
services in foreign countries, through its command over a definite amount of
foreign currency, should remain constant.
(iii)
The system must be economical. A costly medium of exchange is a
national waste. It is unnecessary. That is why all countries use mostly
paper money.
(iv)
The currency must be elastic and automatic so that it expands or
contracts in response to the requirements of trade and industry.
(v)
The currency system must be simple so that an average man can
understand it. A complicated system cannot inspire public confidence.
1.6.Summary:
The international monetary system can be defined as the structure within which
foreign exchange rates are determined, international trade and capital flows are
accommodated, and balance of payments adjustments made. It also includes all the
instruments, and agreements that link together the world`s currency, money
markets, securities, real estate, and commodity markets. The international monetary
system has evolved historically from the gold standard (1876-1913) of fixed
exchange rates, to the interwar years and World War II (1914-1944) with floating
exchange rates, to fixed exchange rates (1945-1973) under the Bretton Woods
Agreement, to the present eclectic currency arrangement (1973-present) of fixed,
floating, and managed exchange rates.
The key monetary institution is the International Monetary Fund (IMF). It was first
proposed in 1944 at Bretton Woods, New Hampshire, with the purpose of being a
lender of last resort to countries facing temporary balance of payments difficulties.
Contemporary currency regimes vary from rigidly fixed rates to managed floating
to independently floating exchange rates. Several countries, such as Argentina and
Hong Kong, utilize currency boards as a means of fixing their exchange rates.
Another alternative being considered is dollarization, which entails the use of the
U.S. dollar as the main domestic currency. The argument over the appropriateness
of fixed rates versus flexible rates continues, as shown by the variety of currency
regimes in use across the globe. Eleven of the 15 member countries of the European
Union successfully launched a single currency effective January 1, 1999. Called the
Euro, this single currency will replace the 11 national currencies of the participant
countries completely by mid-2002. The European Central Bank in Frankfurt,
Germany conducts monetary policy for the 11 member countries of the EMU. The
devaluation of the Mexican peso in 1994 and the subsequent tequila effect was a
harbinger of crises to come. The second half of the 1990s was racked by a series of
currency crises that shook all emerging markets. Three recent crises ? the Asian
crisis (starting in Thailand in July 1997), the Russian crisis (August 1998), and the
Brazilian crisis (January 1999) - demonstrate the critical roles of currencies in the
global economy.
Glossary:
Gold Standard: A system of setting currency values whereby the participating
countries commit to fix the prices of their domestic currencies in terms of a
specified amount of gold.
Bretton Woods Agreement:
The Bretton Woods Agreement, implemented in 1946, whereby each member
government pledged to maintain a fixed, or pegged, exchange rate for its currency
vis-?-vis the dollar or gold. These fixed exchange rates were supposed to reduce the
riskiness of international transactions, thus promoting growth in world trade.
Free Float: An exchange rate system characterized by the absence of government
intervention. Also known as a clean float.
Special Drawing Rights (SDRs): A new form of international reserve assets,
created by the IMF in 1967, whose value is based on a portfolio of widely used
currencies.
Hot Money: Money which moves internationally from one currency and / or
country to another in response to interest rate differences, and moves away
immediately when the interest advantage disappears.
1.7.Self Assessment Questions:
1. Define international monetary system. Briefly explain different forms of
exchange rate systems.
2. What is Gold Standard? Explain the advantages and disadvantages of gold
standard.
3. List out the causes of break-down of the gold standard.
4. What is Bretton Wood`s agreement? Explain the significance of this agreement
in international monetary environment in the post war period.
5. What are the main differences of fixed and flexible exchange rates? Describe
briefly the contemporary currency regimes.
6. What is meant by Special Drawing Rights (SDRs)? Explain their significance
in international monetary environment.
7. What are the essentials of sound currency system?
1.9. Further Readings:
1. Alan C Shapiro, Multinational Financial Management (2002), Prentice-Hall of
India, New Delhi.
2. K K Dewett, Modern Economic Theory (2006), S.Chand & Company Ltd, New
Delhi.
3. Francis Cherunilam : International Economics, Tata Mc Graw Hill Pub Ltd,
New Delhi
4. Ian H Giddy: Global Financial Markets, AITBS Publishers and Distributors,
New Delhi
5. C Jeevanandam, Foreign Exchange: Practice, Concepts, Sultan Chand & Sons,
New Delhi.
Lesson 2: Determinants of Exchange Rates
Objectives:
After studying this lesson you should be able
To know the important determinants of exchange rates.
To understand economic theories that explain long-run exchange rate
determinants
To understand the impact of balance of payments on exchange rate
To know the effect of price changes, interest rates on foreign exchange rates
To study different approaches to exchange rate forecasting
Structure
1.3 Introduction
1.4 Potential Exchange Rate Determinants
1.5 The Balance of Payments Approach
1.6 Parity Conditions
1.7 Interest Rates and Exchange Rates
1.8 The Asset Market Approach
1.9 Technical Analysis
1.10 Summary
1.11 Glossary
1.12 Self Assessment Questions
1.13 Further Readings
1.2 Introduction:
On the most fundamental level, exchange rates are market-clearing prices that
equilibrate supplies and demands in foreign exchange markets. Obviously, it is the
supply of, and the demand for, foreign currency that would determine at any time
the rate of exchange of a country`s currency just as the market price of commodities
is determined by the forces of demand and supply. Managers of multi national
enterprises, international portfolio investors, importers and exporters, and
government officials are very much interested in knowing the determinants of
exchange rates. An important question to be answered is whether change in
exchange rates predictable?
Unfortunately, there is no general theory of exchange rate determination. Instead,
there are economic theories called parity conditions that attempt to explain long-run
exchange rate determinants. Numerous other variables appear to explain short and
medium-run exchange rate determinants. A major problem is that the same set of
determinants does not explain rates for all countries at all times, or even for the
same country at all times.
1.2. Potential Exchange Rate Determinants
Potential foreign exchange rate determinants can be categorized into clusters that
are also influenced by exchange rates. They are: 1) parity conditions; 2)
infrastructure; 3) speculation; 4) cross-border investment; and 5) political risk.
Exhibit 1 provides a road map to identify the potentially most important
determinants that have surfaced in recent years. It is observed that most
determinants of the spot exchange rate are also in turn affected by changes in the
spot rate. In other words, they are not only linked but also mutually determined.
Parity conditions are an explanation in classical economics for the long-rung value
of exchange rates. These conditions will be described in detail in next sections.
Infrastructure weaknesses were among the big cause for the recent collapse of
exchange rates in he emerging markets. On the other hand, infrastructure strengths
helped explain why the US dollar continues to be strong despite record balance-of-
payments deficit on current account.
Exhibit 1
Potential Foreign Exchange Rate Determinants
Parity Conditions
1. Relative inflation rates (purchasing power
Infrastructure
parity)
1. Strength of banking system
2. Relative interest rates (Fisher effect and r
eal
2. Strength of securities markets
interest differentials)
3. Outlook for growth and
3. Forward exchange rates
profitability
4. Exchange rate regimes (fixed vs flexible
rates)
5. Official monetary reserves
Spot Exchange Rate
Speculation
Cross-Bord er Investment
Political Risk
1. Currencies
1. For eign direct
1. Capital controls
2. Securities
inv
estment
2. Black market in
3. Uncovered interest
2. Port folio investment
currencies
arbitrage
3. Exchange rate spreads
4. Real estate
4. Risk premium on
5. Comm odities
securities and FDI
Source: Adapted from text book Multinational Business Finance`, by
David K.Eiteman, Arthur I.Stonehill, Michael H Moffett, Pearson Education
Speculation contributed greatly to the emerging market crises. Some characteristics
of speculation were hot money flows into and out of currencies, securities, real
estate, and commodities. Cross border foreign direct investment and international
portfolio investment into the emerging markets are on the rise in recent times.
Political risks have been much reduced in recent years, as capital markets became
less segmented from each other and more liquid. Cash flows motivated by any and
all of the potential exchange rate determinants eventually show up in the balance of
payments (BOP). The BOP provides a means to account for these cash flows in a
standardized and systematic manner. The BOP increases the transparency of the
whole international monetary environment and enables decision-makers to make
more rational policy choices.
1.3.Balance of Payments Approach
The International Monetary Fund defines the BOP as a statistical statement that
systematically summarizes, for a specific time period, the economic transactions of
an economy with the rest of the world. BOP data measures economic transactions
include exports and imports of goods and services, income flows, capital flows, and
gifts and similar one-sided transfer payments. The net of all these transactions is
matched by a change in the country`s international monetary reserves.
The significance of a deficit or surplus in the BOP has changed since the advent of
floating exchange rates. Traditionally, BOP measures were used as evidence of
pressure on a country`s foreign exchange rate. This pressure led to governmental
transactions that were compensatory in nature, forced on he government by its need
to settle the deficit or face a devaluation.
Exchange Rate Impacts:
The relationship between the BOP and exchange rates can be illustrated by use of a
simplified equation that summarizes BOP data:
BOP = (X-M) + (CI-CO) + (FI-FO) +FXB
Where: X is exports of goods and services,
M is imports of goods and services,
(X-M) is known as Current Account Balance
CI is capital outflows,
CO is capital outflows,
(CI-CO) is known as Capital Account Balance
FI is financial inflows,
FO is financial outflows,
(FI-FO) is known as Financial Account Balance
FXB is official monetary reserves such as foreign exchange and gold
The effect of an imbalance in the BOP of a country works somewhat differently
depending on whether that country has fixed exchange rates, floating exchange
rates, or a managed exchange rate system.
a) Fixed Exchange Rate Countries. Under a fixed exchange rate
system, the government bears the responsibility to ensure a BOP near
zero. If the sum of the current and capital accounts does not
approximate zero, the government is expected to intervence in the
foreign exchange market by buying or selling official foreign exchange
reserves. If the sum of the first two accounts is greater than zero, a
surplus demand for the domestic currency exists in the world. To
preserve the fixed exchange rate, the government must then intervence
in the foreign exchange market and sell domestic currency for foreign
currencies or gold so as to bring the BOP back near zero. It the sum of the
current and capital accounts is negative, an exchange supply of the domestic
currency exists in world markets. Then the government must intervene by buying
the domestic currency with its reserves of foreign currencies and gold. It is
obviously important for a government to maintain significant foreign exchange
reserve balances to allow it to intervene effectively. If the country runs out of
foreign exchange reserves, it will be unable to buy back its domestic currency and
will be forced to devalue. For fixed exchange rate countries, then, business
managers use balance-of-payments statistics to help forecast devaluation or
revaluation of the official exchange rate. Normally a change in fixed exchange
rates is technically called devaluation or revaluation, while a change in floating
exchange rates is called either depreciation or appreciation.
b) Floating Exchange Rate Countries. Under a floating exchange rate system, the
government of a county has no responsibility to peg the foreign exchange rate. The
fact that the current and capital account balances do not sum to zero will
automatically (in theory) alter the exchange rate in the direction necessary to obtain
a BOP near zero. For example, a country running a sizable current account deficit
with the capital and financial accounts balance of zero will have a net BOP deficit.
An excess supply of the domestic currency will appear on world markets. As is the
case with all goods in excess supply, the market will rid itself of the imbalance by
lowering the price. Thus, the domestic currency will fall in value, and the BOP will
move back toward zero. Exchange rate markets do not always follow this theory,
particularly in the short-to-intermediate term.
c) Managed Floats. Although still relying on market conditions for day-to-day
exchange rate determination, countries operating with managed floats often find it
necessary to take actions to maintain their desired exchange rate values. They
therefore seek to alter the market`s valuation of a specific exchange rate by
influencing the motivations of market activity, rather than through direct
intervention in the foreign exchange markets.
The primary action taken by such governments is to change relative interest rates,
thus influencing the economic fundamentals of exchange rate determination. A
change in domestic interest rates is an attempt to alter capital account balance,
especially the short-term portfolio component of these capital flows, in order to
restore an imbalance caused by the deficit in current account. The power of interest
rate changes on international capital and exchange rate movements can be
substantial. A country with a managed float that wishes to defend its currency may
choose to raise domestic interest rates to attract additional capital from abroad. This
will alter market forces and create additional market demand for domestic currency.
In this process, the government signals exchange market participants that it intends
to take measures to preserve the currency`s value within certain ranges. The process
also raises the cost of local borrowing for businesses, however, and so the policy is
seldom without domestic critics. For managed-float countries, business managers
use BOP trends to help forecast changes in the government policies on domestic
interest rates.
1.4.Parity Conditions
There are many potential exchange rate determinants. Economists have traditionally
isolated several of these determinants and theorized how they are linked with one
another and with spot and forward exchange rates. These linkages are called parity
conditions. They are useful in explaining and forecasting the long-run trend in an
exchange rate.
1.4.1. Prices and Exchange Rates:
If the identical product or service can be sold in two different markets, and no
restrictions exist on the sale or transportation costs of moving the product between
markets, the product`s price should be the same in both markets. This is called the
law of one price. A primary principle of competitive markets is that prices will
equalize across markets if frictions or costs of moving the products or services
between markets do not exist. If the two markets are in two different countries, the
product`s price may be stated in different currency terms, but the price of the
product should still be the same. Comparison of prices would only require a
conversion from one currency to the other.
1.4.2. Purchasing Power Parity and the Law of One Price:
If the law of one price were true for all goods and services, the
purchasing power parity exchange rate could be found from any
individual set of prices. By comparing the prices of identical products
denominated in different currencies, we could determine the real or
PPP exchange rate which should exist if markets were efficient. The
hamburger standard, as it has been christened by The Economist, is a
prime example of this law of one price. Assuming that the Big Mac,
food item sold by McDonalds is indeed identical in all countries, it
serves as one means of identifying whether currencies are currently
trading at market rates that are close to the exchange rate implied by
Big Macs in local currencies. A less extreme form of this principle
would say that, in relatively efficient markets, the price of a basket of
goods would be the same in each market. This is the absolute version
of the theory of purchasing power parity. Absolute PPP state that the
spot exchange rate is determined by the relative prices of similar
baskets of goods.
1.4.3. Relative Purchasing Power Parity:
If the assumptions of the absolute version of PPP theory are relaxed a bit more, we
observe what is termed relative purchasing power parity. This more general idea is
that PPP is not particularly helpful in determining what the spot rate is today, but
that the relative change in prices between two countries over a period of time
determines the change in the exchange rate over that period. More specifically, if
the spot exchange rate between two countries starts in equilibrium, any change in
the differential rate of inflation between them tends to be offset over the long run by
an equal but opposite change in the spot exchange rate.
1.4.4. Exchange Rate Indices: Real and Nominal:
Any single country in the current global market trades with numerous partners.
This requires tracking and evaluating its individual currency value against all other
currency values in order to determine relative purchasing power, that is, whether it
is overvalued or undervalued in terms of PPP. One of the primary methods of
dealing with this problem is the calculation of exchange rate indices. These indices
are formed by trade-weighting the bilateral exchange rates between the home
country and its trading partners. The nominal effective exchange rate index
calculates, on a weighted average basis, the value of the subject currency at
different points in time. It does not really indicate anything about the true value
of the currency, or anything related to PPP. The nominal index simply calculates
how the currency value relates to some arbitrarily chosen base period. The real
effective exchange rate index indicates how the weighted average purchasing power
of the currency has changed relative to some arbitrarily selected base period.
1.5. Interest Rates and Exchange Rates
In this section we see how interest rates are linked to exchange rates.
1.5.1. The Fisher Effect:
The Fisher effect, named after economist Irving Fisher, states that nominal interest
rates in each country are equal to the required real rate of return plus compensation
for expected inflation.
1.5.2. The International Fisher Effect:
The relationship between the percentage change in the spot exchange rate over time
and the differential between comparable interest rates in different national capital
markets is known as the international Fisher effect. Fisher-open as it is often
termed, states that the spot exchange rate should change in an amount equal to but
in the opposite direction of the difference in interest rates between two countries.
Empirical tests lend some support to the relationship postulated by the international
Fisher effect, although considerable sort-run deviations occur. However, a more
serious criticism has been posed by recent studies that suggest the existence of a
foreign exchange risk premium for major currencies. Also, speculation in uncovered
interest arbitrage, such as carry trade, creates distortions in currency markets.
Thus the expected change in exchange rates might be consistently more than the
difference in interest rates.
1.5.3.Interest Rate Parity:
The theory of interest rate parity (IRP) provides the linkages between the foreign
exchange markets and the international money markets. The theory states that the
difference in the national interest rates for securities of similar risk and maturity
should be equal to, but opposite in sign to, the forward rate discount or premium for
the foreign currency, except for transaction costs.
1.5.4. Covered Interest Arbitrage:
The spot and forward exchange markets are not, however, constantly in the state of
equilibrium described by interest rate parity. When the market is not in equilibrium,
the potential for riskless or arbitrage profit exists. The arbitrager who recognizes
such an imbalance will move to take advantage of the disequilibrium by investing in
whichever currency offers the higher return on a covered basis. This is called
covered interest arbitrage (CIA).
1.5.5. Forward Rate as an Unbiased Predictor of the Future Spot Rate:
Some forecasters believe that for the major floating currencies, foreign exchange
markets are efficient and forward exchange rates are unbiased predictors of future
spot exchange rates. Intuitively this means that the distribution of possible actual
spot rates in the future is centered on the forward rate. The forward exchange rate`s
being an unbiased predictor does not, however, mean that the future spot rate will
actually be equal to what the forward rate predicts. Unbiased prediction simply
means that the forward rate will, on average, overestimate and underestimate the
actual future spot rate in equal frequency and degree. The forward rate may, in fact,
never actually equal the future spot rate.
1.6. The Asset Market Approach
Along with the BOP approach to long-term foreign exchange rate determination,
there is an alternative approach to exchange rate forecasting called the asset market
approach. The asset approach to forecasting suggests that whether foreigners are
willing to hold claims in monetary form depends partly on relative real interest rates
and partly on a country`s outlook for economic growth and profitability. For
example, during the period 1981-1985 the US dollar strengthened despite growing
current account deficits. This strength was due partly to relatively high real interest
rates in the US. Another factor, however, was the heavy inflow of foreign capital
into the US stock market and real estate, motivated by good long-run prospects for
growth and profitability in the US.
1.7. Technical Analysis
Technical analysts traditionally referred to as chartists focus on price and volume
data to determine past trends that are expected to continue into the future. The
single most important element of time series analysis is that future exchange rates
are based on the current exchange rate. Exchange rate movements, like equity price
movements, can be subdivided into periods: (I) day-to-day movement that is
seemingly random; (2) short-term movements extending from several days to trends
lasting several months; (3) long-term movements, which are characterized by up
and down long-term trends.
The longer the time horizon of the forecast, the more inaccurate the forecast is
likely to be. Whereas forecasting for the long-run must depend on economic
fundamentals of exchange rate determination, many of the forecast needs of the
firm are short-to medium-term in their time horizon and can be addressed with less
theoretical approaches. Time series techniques infer no theory or causality but
simply predict future values from the recent past. Forecasters freely mix
fundamental and technical analysis, presumably because in forecasting, getting
close is all that counts. Exhibit 2 summarizes the various forecasting periods,
regimes, and the preferred methodologies.
Exhibit 2
Exchange Rate Forecasting in Practice
Forecast Period
Regime
Recommended Forecast Methods
Fixed-
1. Assume the fixed rate is maintained
Rate
2. Indications of stress on fixed rate?
3. Capital controls; black market rates
4. Indicators of government`s capability to maintain fixed rate?
5. Changes in official foreign currency reserves
Floating-
1. Technical methods that capture trend
SHORT-RUN
Rate
2. Forward rates as forecasts
a. <30 days, assume a random walk
b. 30-90 days, forward rates
c. 90-360 days, combine trend with fundamental analysis
3. Fundamental analysis of inflationary concerns
4. Government declarations and agreements regarding exchange rate
goals
5. Cooperative agreements with other countries
Fixed-
1. Fundamental analysis
Rate
2. BOP management
3. Ability to control domestic inflation
4. Ability to generate hard currency reserves to use for intervention
LONG-RUN
5. Ability to run trade surpluses
Floating-
1.
Focus on inflationary fundamentals and PPP
Rate
2.
Indicators of general economic health such as economic growth
and stability
3.
Technical analysis of long-term trends; new research indicates
possibility of long-term technical waves
1.8. Summary
Exchange rate in a floating rate system is determined by the demand and supply
forces. The higher the demand or lower the supply, the greater the value of the
currency in the spot foreign exchange market. There are different theories
explaining the exchange rate behaviour. While the balance of payments theory
stresses on the current account and the capital account behaviour influencing the
exchange rate, the monetary theories emphasise on the demand and supply of
money being the main force behind exchange rate behaviour. Some forecasters
believe that for the major floating currencies, foreign exchange markets are
efficient and forward exchange rates are unbiased predictors of future spot
exchange rates. The asset approach to forecasting suggests that whether foreigners
are willing to hold claims in monetary form depends partly on relative real interest
rates and partly on a country`s outlook for economic growth and profitability. The
factors influencing the exchange rate are primarily the inflation rate and interest rate
differentials. In the forward market it is the Interest Rate Parity theory that explains
exchange rate determination.
1.9.Glossary
Balance of Payments: A financial statement summarizing the flow of goods,
services, and investment funds between residents of a given country and residents
of the rest of the world.
Capital account: A section of the balance of payments accounts. Under the revised
format of the IMF, the capital account measures capital transfers and the acquisition
and disposal of non-produced and non-financial assets.
Covering: A transaction in the forward foreign exchange market or money market
which protects the value of future cash flows.
Current account: In the balance of payments, the net flow of goods, services, and
unilateral transfers such as gifts between a country and all foreign countries.
Devaluation: A drop in the spot foreign exchange value of a currency that is
pegged to other currencies or to gold.
Flexible exchange rates: The opposite of fixed exchange rate is adjusted
periodically by the country`s monetary authorities in accordance with their
judgement and/or an external set of economic indicators.
Floating Exchange rates: Foreign exchange rates determined by demand and
supply in an open market that is presumably free of government interference.
Revaluation: A rise in the foreign exchange value of a currency that is pegged to
other currencies or gold. Also called appreciation.
1.10. Self Assessment Questions
1. What are the important foreign exchange rate determinants? Describe briefly
each of them.
2. Define balance of payment (BOP). What is its significance in foreign exchange
rate determination?
3. What are parity conditions? Explain the linkages of prices, interest rates, and
exchange rates in equilibrium.
4. Describe Purchasing Power Parity and the Law of One Price.
5. Explain briefly: (a) Interest Rate Parity (b) Covered Interest Arbitrage (c)
1.11. Further Readings
6. Alan C Shapiro, Multinational Financial Management (2002), Prentice-Hall of
India, New Delhi.
7. K K Dewett, Modern Economic Theory (2006), S.Chand & Company Ltd, New
Delhi.
8. Francis Cherunilam : International Economics, Tata Mc Graw Hill Pub Ltd,
New Delhi
9. Ian H Giddy: Global Financial Markets, AITBS Publishers and Distributors,
New Delhi
10. C Jeevanandam, Foreign Exchange: Practice, Concepts, Sultan Chand & Sons,
New Delhi
Lesson 3: Exchange Controls.
Objectives:
After studying this lesson you should be able
To understand why countries impose exchange controls
To know types of currency control measures followed by various countries
To study the impact of exchange controls on economic environment
Structure
1.14 Introduction
1.15 Possible Courses of Exchange Control
1.3. Methods of Exchange Control
1.4. Forms of Exchange Control
1.5 Summary
1.6 Glossary
1.7 Self Assessment Questions
1.8 Further Readings
1.3 Introduction:
Exchange controls, like currency devaluations, form a part of expenditure-switching
policy package. Because, they, too, like devaluation, aim at directing domestic
spending away from foreign supplies and investment. Exchange controls try to
divert domestic spending into consumption of domestically produced goods and
services on the one hand and into domestic investment on the other.
Exchange controls represent the most drastic means of BOP adjustment. A full-
fledged system of exchange controls establishes a complete government control
over the foreign exchange market of the country. Foreign exchange earned from
exports and other sources must be surrendered to the government authorities. The
available supply of foreign exchange is then allocated among the various buyers
(importers) according to the criterion of national needs and established priorities.
From a purely BOP standpoint, the sole purpose of exchange controls, is to ration
out the available supply of foreign exchange in accordance with national interests.
There are also a variety of milder forms of exchange control which merely limit
certain sources of demand for foreign exchange; there by they try to minimize their
pressure on the BOP deficit. For example, a country may restrict foreign tourism or
foreign study by the nationals of the country, in order to save foreign exchange.
Similarly, domestic residents may restrict some of the capital transfers abroad,
again to conserve scarce foreign exchange. Partial exchange controls such as these
may be scrapped if a more basic improvement in the foreign exchange earnings has
occurred. India at present gained confidence with bulging forex reserves ($165
billion ? November 2006) lifted several controls in recent times. The following
section lists the most frequently used currency control measures. These controls are
a major source of market imperfection, providing opportunities as well as risks for
multinational corporations.
1.1.1. Typical Currency Control Measures:
Restriction or prohibition of certain remittance categories such as dividends or
royalties.
Ceilings on direct foreign investment outflows
Controls on overseas portfolio investments
Import restrictions
Required surrender of hard-currency export receipts to central bank
Limitations on prepayments for imports
Requirements to deposit in interest-free accounts with central bank, for a
specified time, some percentages of the value of imports and/or remittances
Foreign borrowings restricted to a minimum or maximum maturity
Ceilings on granting of credit to foreign firms
Imposition of taxes and limitations on foreign-owned bank deposits
Multiple exchange rates for buying and selling foreign currencies, depending on
category of goods or services each transaction falls into
1.1.2. Objectives of Exchange Control:
The object of controlling exchange is to fix it at a level different from what it would
be if the economic forces were permitted free interplay. The objectives of exchange
control may be:-
(a) To correct a serious imbalance in the economy of the country relatively to
the outside world; or
(b) To conserve the country`s gold reserves which are being depleted; or
(c) to correct a persistently adverse balance of payments; or
(d) to prevent a flight of capital from the country; or
(e) to conserve foreign exchange reserves for large payments abroad; or
(f) to maintain stable exchange rate, or
(g) to ensure growth with stability, and so on.
In all these circumstances, a free exchange would be either embarrassing or
prejudicial to the object in view, and exchange control becomes an imperative
necessity.
1.2. Possible Courses of exchange control:
There are three possible courses that a country adopting exchange control may like
to pursue, considering the economic situation in which it may find itself;
(1) It may like to under-value or depreciate currency; or
(2) it may decide on over-valuation; or
(3) it may decide to avoid fluctuations and maintain a stable rate.
Let us consider when and with what consequences each of these courses may be
adopted.
1.2.1. Under-Valuation
Under valuation is advocated for curing depression. When a country decides on
under-valuation or depreciation, i.e., fixing a rate lower than it would be in a free
exchange market, exports are stimulated and imports are discouraged. It will give
stimulus to export industries and domestic industries will also benefit because
imports have been discouraged. Thus, under-valuation will increase economic
activity in the country, add to the total output (GNP) and will create more
employment.
But this object may not be fulfilled. Instead of internal prices rising, the external
prices may fall. This would happen in the case of a big country like India and the
U.S.A. Also, since prices are affected through exports and imports, the desired
objective of modifying the price level is more likely to be achieved when foreign
trade is extensive than when it forms only a small proportion of the aggregate trade
of the country. The policy of under-valuation is more suitable for a country, whose
exports consist of foodstuffs and raw materials, for during depression, prices of
these goods are depressed to a greater extent. Since, however, under-valuation will
make the imports dear, the purchasing power of the producers of raw materials and
foodstuffs will be reduced. But it is considered more advantageous to prevent a fall
in the prices of goods it has to sell than to prevent a rise in those, which it has to
buy. During the Great Depression (1929-34), many countries adopted a policy of
under-valuation and depreciated their currencies. In fact, there was regular
competition in currency depreciation. Every country tried to cure its own
depression. The Articles of the IMF now rule out competitive exchange
depreciation. If depreciation has to come, it must come in an orderly fashion.
1.2.2. Over-Valuation
The second object of exchange control may be over-valuation or fixing the
valuation of its currency at a level higher than it would be if there was no
intervention in foreign exchange. This course is indicated in the following
situations:
(i)
When there is a serious imbalance in the country`s trade relationship. As a
consequence, the supply of national currency may far exceed the demand for
it.
(ii)
The country may be in great need of foreign goods either for prosecution of
a war or for reconstruction after the war or for economic development. If
exchange rate were permitted to fall in these circumstances, it would make
these much needed imports very costly, or almost prohibitive. When a
country finds itself under the sudden necessity of making large purchases from
abroad, over-valuation is found to be most suitable.
(iii)
If a country is suffering from inflation, the exchange value of the national
currency will go down when exchanges are left free to move. If foreign trade
plays a very important part in the economy of the country, this downward
trend must be arrested by overvaluing the domestic currency, otherwise
imports will become very dear and the exporters will have windfall profits.
(iv)
A policy of over-valuation is also in the interest of a country which has to
meet a large debt payments expressed in foreign currency. If the rate of
exchange fell, the burden of foreign debt would correspondingly increase.
We cannot lay down dogmatically whether a country should under-value or over
value. It all depends on circumstances. Over-valuation may suit certain countries
and under-valuation certain others. The same country may find over-valuation
more suitable at one stage and under-valuation at another. The rough rule-of-thumb,
therefore, is in times of slump and surfeit, under-value your currency.
The third course is neither to under-value nor to over-value but to avoid
fluctuations. Even here the object is not to keep exchanges rigidly fixed but simply
to avoid sudden and big changes. It is intended only to iron out temporary ups and
downs and to keep off the adventitious influences. This was done by Exchange
Equalisation Account, which was explained in next section. The IMF is also
intended to achieve the same objective.
1.3. Methods of Exchange Control:
1.3.1. Influencing Exchange Rate.
Exchange control is exercised either by regulating international movements of
goods through various devices or by the purchase and sale of foreign currency at
specified rates in order to maintain a particular range of exchange fluctuations.
Exchange control can be exercised by influencing demand for, and supply of,
currencies in the exchange market. This can be done indirectly by devices like
tariffs, quotas, bounties, changes in interest rates, etc. Imposition of import duties
and of import quotas will reduce imports, cut down the demand for foreign
currency, lower its value or raise the value of the domestic currency. Export duties,
which are not so common, will have the opposite effect. Bounties affect the other
way about. Export bounty will raise and import bounty (which exists nowhere) will
lower the value of the home currency. A rise in the interest rates attracts funds from
abroad, increases demand for domestic currency and raises its value, and vice versa.
But these are the ways in which exchange is influenced and not controlled. The
effect of such devices can be offset by similar devices adopted by rival nations.
These measures are not necessarily adopted for controlling exchange and are not
sufficiently strong to bring rates of exchange under effective control. Hence, more
direct methods have to be adopted.
1.3.2. Controlling Exchange Rate. There are two methods generally adopted for
controlling exchange:
(a) Intervention. In this case, the government enters the exchange market either to
purchase or to sell foreign exchange in order to bring the rate up or down to the
desired level. This method has been called intervention and leads to exchange
pegging` described in next section.
(b) Restriction. In this case, the government can prevent the existing demand for,
or supply of, the country, in which they are interested, from reaching the
exchange market. This method has been called restriction. The second method
has been more popular because intervention proved a weak weapon and was
also expensive.
1.3.3. Exchange Control Proper. Exchange restriction is exchange control proper.
For this three things are done: (a) all foreign dealings are centralised, usually in the
central bank; (b) the national currency cannot be offered for exchange without
previous permission, and (c) it is made a criminal offence to enter into an
unauthorised foreign exchange transaction.
The usual procedure is to order all exporters to surrender claims on foreign currency
to the central bank and ratio the foreign exchange made so available among the
licensed importers. Exchange, control thus involves import control. Up to 1939,
Germany was a pioneer in the method of exchange control although exchange
control was adopted in several other European countries also during the Great
Depression (1929-33).
1.4. Forms of Exchange Control:
The various forms that exchange control has taken are briefly discussed below:
1.4.1. Exchange Pegging:
This device is usually adopted during war in order to minimize exchange
fluctuations. The internal value of a currency may depreciate due to inflation but
the government may seek to keep its external value at a higher level than warranted
by the purchasing power parity in order to facilitate international transactions.
England during First World War and again in the Second World War adopted the
method. Between 1916 and 1919, the Sterling was kept artificially pegged at 4.765
dollars ? a value which was higher than the real value of the Sterling. This was
done by raising loans in America and through these funds, purchasing exchange in
London at the above rate. Success in exchange pegging evidently depends on the
resources at the command of the nation. Exchange pegging can iron out more or
less sporadic and adventitious fluctuations and cannot avoid fundamental changes in
the equilibrium rates of exchange.
1.4.2. Exchange Equalisation Account:
Exchange funds were the outgrowth of the transformation of the international gold
standard convention into an international gold settlement system under which gold
came to be used as a balancing item in international trade.
After the suspension of the gold standard in 1931 by England, there again arose the
necessity of preventing violent exchange fluctuations. For this purpose, the device
of the Exchange Equalisation Account (or Exchange Stabilisation Fund) was
utilised. An Exchange Stabilisation Fund is a collection of assets segregated under
a central control for the purpose of intervention in the exchange market to prevent
undesirable fluctuations in exchange rate. Foreign currency was purchased or sold,
as the necessity arose, with the help of this fund, and thus exchange was kept within
a narrow range in the face of uncertain movements of short-term funds into and out
of England. The Fund is not used to prevent long-term adjustments in the value of
the currency concerned.
The purposes for which Exchange Stabilisation Funds have been used have differed
in different countries and in the same country at different stages. The aim of the
British Exchange Equalisation Account was that the Account was designed, without
resisting general trends, to iron out undue fluctuations in the exchanges caused by
erratic movements of capital and the disturbing activities of the speculators.
Gradually, the object of the fund was extended, and it was used to combat seasonal
exchange fluctuations. The major purpose of other Exchange funds was to establish
and define appropriate exchange levels, i.e., to resist general trends in the exchange
rates.
In a general way, we can say that the main purposes of such Funds are: (I) to iron
out short-term fluctuations in the rates of exchange, and (ii) to safeguard against the
disturbing influences arising out of the movements of short-term funds and of
speculative activities.
Continually, fluctuating exchanges seriously hamper trade. The Fund is, therefore,
meant to facilitate the smooth course of foreign trade. By similar devices the dollar-
sterling rate was maintained at ? 1 = 4.03 dollars during World War II.
1.4.3. Other Exchange Control Devices:
Strictly speaking, the term exchange control is applied to several devices most of
which were first introduced in Germany during the Nazi regime. Later, other
countries also adopted some of them. Such devices are: (a) Clearing Agreements.
(b) Standstill Agreements, (c) Transfer Moratoria, and (d) Blocked Accounts.
(a) Clearing Agreements: Under a clearing agreement between two countries,
importers in both countries pay into an account at their respective central banks
the purchase price of the goods imported. This money is then used to pay off
exporters. The rate between the currencies is usually fixed by the terms of
agreement. The object is to regulate imports according to the wishes of the
government, to ensure equilibrium in the balance of payments and to prevent
uncertainties of fluctuating exchanges. The system tends to encourage bilateral
trade at the expense of multilateral trade and thus has a restrictive effect on
international trade. On the other hand, it discourages dumping and currency
depreciation. On the whole, the system stands condemned except under special
circumstances of a war or as a temporary measure to tide over a period of
disequilibrium in a country`s balance of payments until the basic causes of such
a disequilibrium have been removed.
(b) Standstill agreement: A standstill agreement is a device to prevent the
movement of capital through a moratorium on outstanding short-term foreign
debts of a country and to give her time to put her house in order. Either the
short-term debt is converted into long-term debt or provision is made for its
gradual repayment. This device was used in Germany after the crisis of 1931.
(c) Transfer moratoria: It is another device of the same kind. Under this system,
importers or others pay their foreign debts in their domestic currency to a
specified authority. When the moratorium is concluded these funds are remitted
abroad. A foreign creditor is sometimes allowed to use his funds in the country
imposing the moratorium in a way specified by the government.
(d) Blocked accounts: This spring from the previously considered two devices of
standstill agreement and transfer moratoria. When foreign debts paid in
domestic currency to the central bank cannot be remitted abroad without the
permission of the government, blocked accounts are said to arise. Since idle
funds in the country lead to contraction of credit, the foreign creditors are not
altogether prevented from using them. But they have to be used in manner
prescribed by the government. Usually, they are allowed to be sold in the open
market. In most cases, they are sold at a heavy discount.
1.8.Summary
Many governments attempt to achieve a balance-of-payments equilibrium by
imposing exchange controls. Exchange controls have become a way of life in most
developing countries. Nations with overvalued currencies ration foreign exchange,
while countries facing revaluation, may restrict capital inflows. In effect,
government controls supersede the allocative function of the foreign exchange
market. The most drastic situation is when all foreign exchange earnings must be
surrendered to the central bank, which, in turn, apportions these funds to users on
the basis of government priorities. The buying and selling rates need not be equal,
nor need they be uniform across all transaction categories. The exchange controls
are a major source of market imperfection, providing opportunities as well as risks
for multinational corporations.
1.9.Glossary:
Capital flight: Movement of funds of a country because of political risk.
Capital mobility: The degree to which private capital moves freely from country to
country seeking the most promising investment opportunities.
Contagion: A form of financial panic, in which the devaluation of exchange rates
by one country leads to similar devaluations at about the same time by other, often
nearby, countries.
Freely floating exchange rates: Exchange rates determined in a free market
without government interference.
IMF: International Monetary Fund (IMF) is an international organization created in
1944 to promote exchange rate stability and provide temporary financing for
countries experiencing balance of payments difficulties.
1.10. Self Assessment Questions:
1. What do you understand by exchange control? Discuss its objectives.
2. What are the typical currency control measures normally adopted by different
countries?
3. What are the different methods of exchange control?
4. Describe briefly: (a) Exchange Pegging (b) Exchange Equalisation Account
1.8 Further Readings:
11. Alan C Shapiro, Multinational Financial Management (2002), Prentice-Hall of
India, New Delhi.
12. K K Dewett, Modern Economic Theory (2006), S.Chand & Company Ltd, New
Delhi.
13. Francis Cherunilam : International Economics, Tata Mc Graw Hill Pub Ltd,
New Delhi
14. Ian H Giddy: Global Financial Markets, AITBS Publishers and Distributors,
New Delhi
15. C Jeevanandam, Foreign Exchange: Practice, Concepts, Sultan Chand & Sons,
New Delhi
UNIT-III
In this unit our aim is to introduce the reader the important transactions
associated with Foreign exchange. The Unit is divided into two chapters. In the first
chapter we discuss the various facets of foreign exchange transactions. The second
chapter discusses the transactions carried out by the important participants in the
foreign exchange market viz., the merchant transactions and inter-bank transactions.
CHAPTER 1
FOREIGN EXCHANGE TRANSACTIONS
Introduction:
In the globalized economic environment of today, economic activity is
globally unified to an unprecedented degree. Thus, changes in one nation`s
economy are rapidly transmitted to that nation`s trading partners. These fluctuations
in economic activity are reflected, almost immediately in fluctuations in currency
values.
The movements of capital across the countries of the world taking the form
of foreign direct investment, by Multinational Corporations involve to a greater
extent the transaction in the alien countries currencies.
In the domestic economy financial management is concerned with costs of
financing sources and the pay offs from investment. However, in the domestic
economy movements of exchange rates are substantially ignored. While one move
outside into international arena, there is no way that we can analyze international
financing and investment opportunities without an understanding of the impact of
foreign exchange rates. Foreign investments aimed at overcoming foreign market
regulations, reducing production costs, taking advantage of new market
opportunities etc. are by no means new or recent origin. However, certain new
trends and dimensions of such investments are discernible. The globalization of
business has created new trading environment emerging from economic integration
and trade agreements among the countries of the world. Economic liberalization in
many countries initiated a proactive role by companies with large cash surpluses to
venture into foreign business.
If money is the language of business, foreign exchange is the language of
international business. In this respect our aim in this unit is to discuss the various
facets foreign exchange transactions.
FOREIGN EXCHANGE -- MEANING:
When trade takes place between the residents of two countries, the two
countries being a sovereign state have their own set of regulations and currency.
Due to this problem arises in the conduct of international trade and settlement of the
transactions .While the exporter would like to get the payment in the currency of his
own country, the importer can pay only in the currency of the importers country.
This creates a need for the conversion of the currency of importer`s into that of the
exporter`s country. Foreign exchange is the mechanism by which the currency of
one country is gets converted into the currency of another country. The conversion
is done by banks who deal in foreign exchange.
FOREIGN EXCHANGE RATE:
When one currency is converted into another, there must be some basis in
effecting the conversion. The basis by which the currency unit of one country gets
converted into currency units of another country is known as foreign exchange rate.
Foreign exchange rate is therefore the price of one currency in terms of another.
The rate of exchange for a currency is known from the quotation in the foreign
exchange market.
FOREIGN EXCHANGE MARKET:
Unlike commodity market where we see specific locations dealing various
commodities, there is no specific locations for foreign exchange market. An
American company importing goods from Germany with their price denominated in
Deutschmark may buy marks in order to pay for the goods. An American company
exporting goods to Germany, again with the price denominated in marks receives
Deutschmarks which it may sell in exchange for dollars. The currency aspects of
these transactions involve use of the foreign exchange markets. Foreign exchange
market exists even in a remote village where the villager approaches a bank of his
village to get converted the remittance received from his relative working abroad.
To that extent, foreign exchange market exists throughout the world. However, the
volumes of transactions in these markets are so few that they are not well
recognized as foreign exchange markets. Based on the volume of transactions
carried out, we can distinguish foreign exchange markets like London, New York,
Tokyo, etc. However, in most of these centers, the foreign exchange market has no
central, physical market place. Business is conducted by telephone or telex. The
main dealers are commercial banks and central banks.
FACTORS THAT AFFECT THE EQUILIBRIUM EXCHANGE RATE:
Some of the factors that influence currency supply and demand are balance
of payments, inflation rates, interest rates economic growth and political and
economic risks.
Balance of Payments:
Foreign exchange rate is the price of one currency in terms of another. The
balance of payments summarizes the flow of economic transactions between
residents of a given country and the residents of other countries during a certain
period of time. Balance of payments represents the demand and supply of foreign
exchange which ultimately determine the value of the currency. When the balance
of payments of a country is continuously deficit, it implies that the demand for the
currency of the country is lesser than its supply. Therefore, its value in the market
declines. If the balance of payments is surplus continuously, it shows that the
demand for the currency in the exchange market is higher than its supply and
therefore the currency gains value.
Relative Inflation Rates:
Suppose that the supply of dollars increases relative to its demand. This
excess growth in the money supply will cause inflation in the US, which means that
US. Prices will begin to rise relative to prices of German goods and services,
German consumers are likely to buy fewer US. products and begin switching to
German substitutes leading to a decrease in the amount of euros supplied at every
exchange rate.
Similarly higher prices in the United States will lead American consumers to
substitute German imports for U.S. products, resulting in an increase in the demand
for euros. In effect both Germans and Americans are searching for the best deals
worldwide and will switch their purchases accordingly. Hence a higher rate of
inflation in the United States than in Germany will simultaneously increase German
exports to the United States and reduce U.S. exports to Germany.
In other words a higher rate of inflation in the United States than in
Germany will lead to depreciation of the depreciation of the dollar relative to the
euro or, to an appreciation of the euro relative to the dollar. In general, a nation
running a relatively high rate of inflation will find its currency declining in value
relative to the currencies of countries with lower inflation rates.
Relative Interest rates:
Interest rate differentials will also affect the equilibrium exchange rate. A
rise in US interest rates relative to German rates all else being equal, will cause
investors in both nations to switch from euro to dollar-denominated securities to
take advantage of the higher dollar rates. The net result will be depreciation of the
euro in the absence of government intervention.
It should be noted that the interest rates discussed here are real interest rates.
The real interest rate equals the nominal or actual interest rate minus the rate of
inflation. The distinction between nominal and real interest rates is critical in
international finance. If the increase in U.S. rates relative to German rates just
reflects higher U.S. inflation, the predicted result will be a weaker dollar. Only an
increase in the real U.S. rate relative to the real German rate will result in an
appreciating dollar.
FOREIGN EXCHANGE TRANSACTIONS:
Purchase and Sale Transactions:
The transaction in foreign exchange market is synonymous with
commodity market. While a trader has to purchase goods from his suppliers
which he sells to his customers, in a similar way the bank which is authorized
to deal in foreign exchange purchases as well as sells its commodity--the
foreign currency. Therefore, the foreign currency can be considered as a
commodity in foreign exchange dealings.
Whenever we talk about foreign exchange two points need to be kept in
mind viz., the transaction is always from the bank`s point of view; and the item
referred to is the foreign currency. Therefore, when we say a purchase, we imply
that the bank has purchased; and it has purchased foreign currency. Similarly, when
we say a sale, we imply that the bank has sold; and it has sold foreign currency. In a
purchase transaction the bank acquires foreign currency and parts with home
currency. In a sale transaction the bank parts with foreign currency and acquires
home currency.
FOREIGN EXCHANGE TRANSACTION
PURCHASE
SALE
BANK
BANK
ACQUIRES
PARTS
ACQUIRES
PARTS
FOREIGN WITH HOME
HOME
WITH
CURRENCY CURRENCY CURRENCY
FOREIGN
CURRENC
Y
EXCHANGE QUATATIONS:
Methods of Quotation:
The exchange rate may be quoted in two ways. 1. Direct quotation
or home currency quotation and 2.Indirect quotation or foreign currency
quotation. For instance, a fruit vendor may express the price of apples in either
of the following two ways:
Method I
One apple costs Rs.10
Method II
For Rs.100, 10 apples
In both the case the value of apple or the rupee is the same though expressed
differently .In method I, the price per apple is quoted in rupees. In method II,
the unit of rupees kept constant at 100, and the quantity of fruits is varied to
reflect their prices.
The same is also true for foreign currency. In foreign exchange also
the rate of exchange can be quoted in two ways:
Method I
USD 1= Rs.43.20 or USD 1=43.30
Method II
Rs.100 = USD 2.3409 or Rs.100 = 2.3200
The quotation under Method I, in which exchange rate is expressed as the
price per unit of one US dollar in terms of the home currency is known as Home
Currency Quotation` or Direct Quotation`. It may be noted that under direct
quotation the number of units of foreign currency is kept constant and any change in
the US dollar quoted at under different values of rupees.
Under Method II, the unit of home currency is kept constant and the
exchange rate is expressed as so many units of foreign currency for a fixed unit of
home currency is known as Foreign Currency Quotation` or Indirect Quotation`.
Under indirect quotation, any change in exchange rate will be effected by changing
the number of units of foreign currency. For instance, the rate Rs.100=USD 2, 3400
may become in due course USD 2.2450 or USD 2.3785, and so on.
The indirect quotation is used in London foreign exchange market. In New
York and other foreign exchange markets mostly the direct method is in vogue.
In India, earlier we had used indirect method. However, from August 2, 1993,
India has switched over to direct method of quotation. The change has been
introduced in order to simplify and establish transparency in exchange rates in
India.
TRANSACTIONS UNDER DIRECT AND INDIRECT QUOTATIONS:
Under direct quotation the bank buys the foreign currency at lower price and
selling it to a customer at a higher price. For instance a bank may buy US dollar at
Rs.46 and sell at 46.20 and thus book a profit. Therefore, under direct quotation the
maxim is buy low; Sell high.
In the case of indirect quotations, while buying, the bank would acquire
more units of foreign currency for a fixed unit of home currency and while selling
part with lesser units of foreign currency for more units of home currency.
Therefore, the maxim under indirect quotation is buy high and sell low.
TWO WAY QUOTATIONS:
The first area of mystique in foreign exchange quotations arises from the
fact that there are two ways of quoting rates; the direct quote and the indirect quote
that we already discussed. The former gives the quotation in terms of the number of
units of home currency necessary to buy one unit of foreign currency. The latter
gives the quotation in terms of the number of units of foreign currency bought with
one unit of home currency.
Foreign exchange dealers quote two prices, one for selling and the other for
buying. Therefore, in the foreign exchange market; quotations are always for both
buying and selling. For instance a bank may quote its rate for dollars as follows:
One US dollar=Rs.46.57- 46.75 or Rs.100=USD 2.2432- 2.2768. While in the case
of One US dollar=Rs.46.57- 46.75 the first Rs.46.57 is the buying rate, the second
46.75 is the selling rate. On the other hand in the case of Rs.100=USD 2.2432-
2.2768, the bank agrees to sell at the rate of USD 2.2432 for Rs.100, the bank is
willing to buy at USD 2.2768 for Rs.100. The buying rate is known as the bid rate
and the selling rate is known as offer rate.
Continental European dealers normally quote via the direct method. In
London dealers use the indirect method. In the US, both quotation methods are
used. When a bank is dealing with a customer within the US direct quotation is
given but when dealing with other banks in Europe (except the UK) the indirect
quotation is used. Foreign exchange dealers quote two prices: the rate at which they
are prepared to sell a currency and that at which they are prepared to buy. The
difference between the bid rate and the offer is the dealer`s spread which is one of
the potential sources of profit for dealers. Whether using the direct quotation
method or the indirect quote, the smaller rate is always termed the bid rate and the
higher is called the offer or ask rate.
The size of the bid/offer spread varies according to the depth of the market
and its stability at any particular time. Depth of a market refers to the volume of
transactions in a particular currency. Deep markets have many deals, shallow
markets have a few. High percentage spreads are associated with high uncertainty
and low volume s of transactions in a currency. Lower spreads are associated with
stable, high volume markets. Deep markets usually have narrower spreads than
shallow one.
SPOT AND FORWARD TRANSACTIONS:
In foreign exchange transactions the transactions are not completed on the
same date. The actual exchange of currencies may take place at different time
periods For instance let us suppose that there are two banks in the foreign exchange
transaction. Bank of India agrees to buy from Bank of Baroda, British pounds one
lakh. The actual exchange may take place (1) on the same day or (2) two days later
or (3) Some day late say after a month. In case 1.where the agreement to buy and
sell is agreed upon and executed on the same date, the transaction is known as cash
transaction`. It is also known as value today`. In case 2, if the settlement takes
place, within two days, the rate of exchange effective for the transaction is known
as spot rate. In case 3, while the delivery and payment takes place after a month,
then the transaction in which the exchange of currencies takes place at a specified
future date is known as forward transaction. The forward transaction is an
agreement between two parties requiring the delivery of some specified future date
of a specified amount of foreign currency by one of the parties against payment in
domestic currency by the other party at the price agreed upon in the contract. The
rate of exchange applicable to the forward contract is called the forward exchange
rate and the market for forward transaction is known as forward market.
Cross Rates:
A cross rate may be defined as an exchange rate which is calculated from
two (or more) other rates. Thus the rate for the Deutschmark to the Swedish crone
will be derived as the cross rate from the US dollar to the Deutschmark and the US
dollar to the crone. The practice in world foreign exchange market is that currencies
are quoted against the US dollar. If one bank asks another bank for its Deutschmark
rate, that rate will be quoted against the US dollar unless otherwise specified. Most
dealings are done against the US dollar hence it follows that the market rate for a
currency at any moment is most accurately reflected in its exchange rate against the
US dollar. A bank that was asked to quote sterling against the Swiss franc would
normally do so by calculating this rate from the sterling/dollar rate and the
dollar/Swiss franc rate. Thus, the cross rates would be used to determine the
quotations.
This could be explained with the help of an illustration. Let us suppose that
we require a quote for Swiss francs against the Deutschmark. The quotation which
we would receive was derived through the quote of both currencies against US
dollar. If these rates against the dollar were $1=Sfr 1.1326/1.1336 and
$1=DM1.3750/1.3755, it would be possible to derive the cross rate for the Swiss
franc against Deutschmark. Our aim is to derive the selling and buying rates for
Swiss francs in terms of Deutschmarks. If we are selling Swiss francs we will be
buying Deutschmarks. So we begin with the rate for selling Swiss francs and
buying dollars; we then move to selling dollars and buying Deutschmarks. The
amalgamation of these two rates gives us the rate for selling Swiss francs and
buying Deutschmarks. The rate for selling Swiss francs to the dealer and buying
dollars is Sfr 1.1336; the rate for selling Swiss dollars and buying Deutschmarks is
DM 1.3750. So selling $0.8822 gives DM1.2120. Thus the rate for selling Swiss
francs and buying Deutschmarks is Sfr 1=DM 1.2130, or DM1=Sfr 0.8244.
Example: Let us assume that the inter bank rate for US dollar to Indian rupee is
$1=Rs.34.2400 ? 34.2600 and the rates in the inter bank for US dollar and French
franc are $1=French fr 4.9660 -4.9710. From the above information we can arrive
at the rupee franc rate as follows:
In the first instance the customer buys US dollar from the market in India at
$1 selling rate of Rs.34.2600.The US dollar thus acquired is disposed off in the
London market for French franc at the market buying rate $1=French franc4.9660.
Therefore the rupee franc rate is:
French franc 1= 34.2600/4.9660=6.8989.
Rounded off to Rs. 6.8990.
Cross rates and Chain rule:
The fixing of rate of exchange between the foreign currency and Indian
rupee through the medium of some other currency is done by what it is known as
Chain rule`. The rate thus obtained is the Cross rate` between these currencies.
For example, let us assume that in the inter bank market dollar is quoted at Rs.42.50
and at Singapore market dollar is quoted at CHF 1.8000. From this information the
rate of exchange of Swiss Franc in terms of rupees may be calculated as follows:
? RS =CHF 1 .............. (1)
If CHF 1.8000 =USD 1 .............. (2)
And USD 1 =Rs.42.50 ............ (3)
It should be noted that the currency which appears as the second item (right hand
side) in the first equation appears as first item (left hand side) in the next equation.
Thus franc appears on the right hand side in the first equation left hand side in the
second equation. US dollar which appears on the right hand side in the second
equation appears on the left hand side in the third equation. The rate of exchange
between Indian rupee and Swiss franc can be calculated by dividing the product of
the right hand side by the product of the left hand side.
42.50 x 1 x 1 = Rs.26.5620
1.8000
Ready Rates Based on Cross Rates:
In the international foreign exchange market, the exchange rates for other
currencies are quoted in the basis of the rates for the currency in terms of US dollar.
They have to be converted into rupee terms before quoting to the customers.
Exchange quotations in international markets:
With a few exceptions, in the international markets, all rates are quoted in
against US dollar. For instance, at Singapore Swiss Franc may be quoted at
1.5425/5440 and Japanese Yen at 104.67/70. This should be understood as:
USD 1 = CHF 1.5425 ? 1.5440
USD 1 = JPY 104.67 ? 104.70
While interpreting an international market quotation, we may do that either
from the variable currency or the standard currency, viz., the dollar. In the above
quotation, in which Swiss Francs are received in exchange for dollars as: (a)
purchase of Swiss Francs against Dollar or (b) sale of Dollar against Swiss Francs.
For the sake of uniformity we will assume the standard currency as the currency
being bought or sold.
The quotation for Swiss Franc is CHF 1.5425 and CHF 1.5440 per Dollar.
While buying dollar the quoting bank would part with fewer francs per dollar and
while selling dollars would require as many francs as possible. Thus CHF1.5425 is
the dollar buying rate and CHF1.5440 is the dollar selling rate. It may be observed
that when viewed from dollar the exchange quotation partakes the character of a
direct quotation and the maxim Buy low; Sell high` is applicable. We will denote
such rates as Dollar/Foreign Currency Rates`, implying that dollar is being bought
or sold against foreign currency.
Few currencies such as pound sterling and Euro are quoted in variable units
of USD. They are quoted as so many US dollars per unit of foreign currency
concerned.
The standard currency here is the foreign currency and will indicate such quotation
as Foreign Currency/Dollar Rate`, the quotation for buying and selling of foreign
currency against dollars.
Forward Margin/Swap Points
Dollar/Foreign Currency Quotation
At Singapore market dollar may be quoted against Swiss franc and Japanese yen as
follows:
Swiss Franc
Japanese Yen
Spot
1.5425/40
104.67/70
1 month forward
50/60
17/16
2 months forward
70/80
30/29
The forward margin (also called swap margin or swap points) is quoted in
terms of points and a point is the last decimal place in the exchange quotation. It
could be in a four digit quotation, a point is 0.0001 or in a two decimal quotation
like 0.01.
If the forward margin is ascending order then forward margin is at premium.
Premium is added to the spot rate to arrive at the forward rates, both in respect of
purchase and sale transactions. The forward margin is given in descending order
then forward margin is at discount and deducted from the spot rate to arrive at the
forward buying and selling rate.
Using the information already available, the forward rates for dollar against
Swiss franc are arrived at as follows:
Dollar
Dollar
Buying
Selling
1 month forward
CHF 1.5475
1.5500
2 months forward
CHF 1.5495
1.5520
As against Japanese Yen, the forward dollar is at a discount, i.e., the forward
margin is in descending order. Therefore, discount is deducted from the spot rate to
arrive at the forward rate, both for buying and selling.
The forward rates for dollar against, Japanese Yen based on the data already
given are as follows:
Dollar
Dollar
Buying
Selling
1 month forward
JPY 104.50
104.54
2 months forward
JPY 104.37
104.41
Foreign Currency / Dollar Quotation
Let us assume the following exchange rates are prevailing:
Pound Sterling
Euro
Spot
1.4326/48
1.0325/35
1 month forward
50/53
65/62
2 months forward
90/93
84/82
Against dollar, the forward pound sterling is at premium. Premium should
be added to the spot rate to arrive at the forward rate.
Thus the forward rates for pound sterling are as follows:
Pound Sterling
Pound Sterling
Buying
Selling
1 month forward
USD 1.4371
1.4401
2 months forward
USD 1.4416
1.4441
Forward Euro is at discount, since the forward margin is quoted in the
descending order. Discount should be deducted from the spot rate to arrive at the
forward rate.
Based on the data given, forward rates for Euro can be arrived at as follows:
Euro
Euro
Buying
Selling
1 month forward
USD 1.0260
1.0273
2 months forward
USD 1.0241
1.0253
DETERMINATION OF FORWARD EXCHANGE RATES:
Forward rate may be the same as the spot rate for the currency then it is
expressed as at par` with the spot rate. Forward exchange operations carry the same
credit risk as spot transactions but for longer periods of time; however, there are
significant exchange risks involved. It is necessary to consider how forward rates
are quoted by foreign exchange dealers. A forward foreign exchange contract is an
agreement between two parties to exchange one currency for another at some future
date. The rate at which the exchange is to be made, the delivery date and the
amounts involved are fixed at the time of agreement.
The forward rate for a currency may be costlier or cheaper than its spot rate.
The difference between the forward rate and the spot rate is known as the forward
margin` or, swap points` The forward margin may be either at premium, or at`
discount`. If the forward margin is at premium, the foreign currency will be costlier
under forward rate than under the spot rate. If the forward margin is at discount, the
foreign currency will be cheaper for forward delivery than the spot delivery.
Consider an example in which the US dollar is the base currency and the
Deutschmark is the quoted currency. Assume that the spot rate is $1=DM1.3753.
The rate quoted by a bank today for delivery in three months` time (today`s three
months forward rate) is $1=DM1.3748. In this example, the dollar buys fewer
Deutschmarks in three months` time than it does today. So the Deutschmark is more
expensive in the forward market. Thus the dollar stands at a discount relative to the
Deutschmark; conversely, the Deutschmark stands at a premium relative to the
dollar. The size of the dollar discount or Deutschmark premium is the difference
between 1.3753 and 1.3748 that is, 0.05 Pfennig`s. The convention in the foreign
exchange market is frequently to quote in terms of points, or hundredths of a unit.
Hence 0.05 Pfennig`s is frequently quoted as 5 points.
In order to arrive at the forward pieces, the deutschmark premium or dollar
discount must be subtracted from the spot rate. Were there a deutschmark discount
or dollar premium, this would be added to the spot rate. But care has to be taken: in
our example used a New York indirect quote. Had we used a New York direct
quote, the reverse would apply: in other words, the deutschmark premium or dollar
discount would have to be added to the spot quotation. An easier way to deal this
problem is always to remember (and this has never, in practice, been found to be
otherwise) that the bid/offer spread on the forward quote is always wider than the
spread on the spot figure. If this is remembered it is an easy process to compare the
two spreads and if the forward spread is narrower than the spot spread, the sums
have been done incorrectly and re-computation is necessary.
Calculation of forward margin:
Example: The forward margin can be calculated for a specific period given the spot
rate and interest differential. Let the spot rate and interest rate differential are as
follows: Spot rate $1=Deutschmark 1.5000 and the interest rate differential is equal
to 8 per cent(US 3.5% and DEM 11.5%).Let us also assume that the no. of days in a
year to be 360 days and the forward margin is for a period of 180 days or 6 months.
The forward margin therefore is
Forward period X Interest Differential X Spot rate
Forward Margin = 100x No. of days in the year
180 x 8 x 1.5000
= 100 x 360
The Forward margin for 180 days = 0.0600. The forward rate is obtained by
adding the forward margin to spot rate. Forward rate is equal to Spot rate plus or
minus forward margin.
Forward Quotations:
The forward quotations for a currency will be quoted with the following
information viz., the spot rate and the forward margin. Given this the forward rate
has to be calculated by loading the forward margin into the spot rate.
Example: On 25th January in the Inter bank market the US dollar is quoted as
follows:
Spot US$1=Rs. 42.4000/2100
Spot/February 2000/2100
Spot/March 3500/3600
In the above quotation, the first statement is the spot rate for dollars, the first
the buying rate Rs.42.4000 and the second Rs.42.4200 the selling rate while the one
given as spot February and spot March are forward margins for the above moths
respectively. The margin is expressed in a point that is 0.0001 of the currency.
Therefore, the forward margin for February is 20 paise and 21 paise. Under direct
quotation, the first rate in the spot quotation is for buying and second for selling
foreign currency. Correspondingly, in the forward margin, the first rates relate to
buying and second the selling. Taking spot/February as example, the margin of 20
paise is for purchase and 21 paise for sale for foreign currency. Where the forward
margin for a month is given in ascending order, it indicates that the forward
currency is at premium. The outright forward rates arrived at by adding the forward
margin to the spot rates.
Example: Buying rate Selling rate
February March February March
Spot rate 42.4000 42.4000 42.4200 42.4200
Add: Premium 0.2000 0.3500 0.2100 0.3600
Forward rates 42.6000 42.7500 42.6300 42.7800
Now we got from the above calculation the outright rates.
Buying selling
Spot delivery USD 1 = Rs.42.4000 42.4200
Forward delivery February 42.6000 42.6300
Forward delivery March 42.7500 42.7800
On the other hand if forward currency is at discount the quotation will be
indicated by quoting the forward margin in the descending order. For instance if the
quotation for inter bank market for pound sterling on 20th April as follows:
Spot GBP 1 = Rs. 68.4000/4300
Spot/May 3800/3600
Spot/June 5700/5400
In this example the forward margin is in descending order (3800/3600) then
the forward sterling rate would be at discount. The forward rates can be calculated
as follows:
Ex: Buying rate Selling rate
May June May June
Spot rate 68.4000 68.4000 68.4300 68.4300
Less discount 0.3800 0.5700 0.3600 0.5400
Forward rates 68.0200 67.8300 68.0700 67.8900
Thus we get the outright rates of pound sterling as follows:
Buying selling
Spot delivery GDP1 = Rs.68.4000 68.4300
Forward delivery May 68.2000 68.0700
Forward delivery June 67.8300 67.8900
FACTORS DETERMINING FORWARD MARGIN:
We have already defined forward margin as the difference between the spot
rate and forward rate of a currency, making the forward currency cheaper or costly
as
compared to the spot currency. The difference in the rate of interest prevailing at
different financial centre is a dominant factor determining forward margin. Other
factors that affect forward margin are demand and supply of currency, speculation
about spot rates and exchange control regulations.
Rate of Interest:
The difference in the rate of interest prevailing at the home centre and the
concerned foreign centre determines the forward margin. If the rate of interest at the
foreign centre is higher than that prevailing at the home centre, the forward margin
would be at discount. Conversely if the rate of interest at the foreign centre is lower
than that at the home centre, the forward margin would be at premium. This can be
explained as follows: When the bank enters into a forward sale contract with the
customer it arranges for delivery of the foreign currency on the due date by keeping
the funds in deposit at the foreign centre concerned. If the interest rate is higher at
the foreign centre concerned, the net gain to the bank is passed on the customer by
offering the forward rate at a discount. If the interest rate is lower at the foreign
centre, the bank suffers a net loss and the loss is passed on to the customer by
quoting, the forward rate at a premium
Demand and Supply:
The demand for and supply of foreign currency to a very great extent
determines the forward margin. In the foreign exchange market if the demand for
foreign currency is more than its supply, forward rate would at premium. On the
other hand if the supply exceeds the demand then the forward rate would be at
discount. Profit motivated investors who want to gain out of the interest rate may
try to borrow from low interest centre and invest in high interest centre. For
example the investor may borrow at New York at (6%) and invest in Mumbai at
(12%). In order to secure his position he may try to cover the transaction in the
forward market. Then he will sell spot dollar and buy forward dollar. When many
such investors do this with the intension of booking profit in the market, then the
supply of spot dollar increases and pushes the price upwards. Thus the difference
between spot and forward rate widens. The force of demand and supply may take
the premium on forward even beyond the limit set by interest differential.
Therefore, it is not just interest differential alone that determines the forward
margin. Sometimes it may also be stated that the loss on account of this premium
may exceed the gain on account of interest differential on the investment. In that
case there is no point in carrying out the plan of investment.
Speculation about Spot Rates:
The spot rates form the basis for determining forward rates. And therefore,
any speculation about spot rates would influence forward rates also. If the
exchange dealers anticipate the spot rate to appreciate, the forward rate would be
quoted at premium. If they expect the spot rate to depreciate, the forward rate
would be quoted at a discount.
Exchange Regulations:
Exchange control regulations enforced by the governments of the nations
also influences the forward margin. And these regulations may put some conditions
on the forward dealings and may obstruct the influence of the other factors on the
forward margin. Such restrictions may include keeping of balances abroad,
borrowing overseas etc. Intervention in the forward market by the central bank may
also be done to influence the forward margin.
Summary and Conclusions:
In this chapter we have understood the meaning of foreign exchange, foreign
exchange rate and foreign exchange market. We have also discussed the basics of
foreign exchange transactions ? direct and indirect quotations, spot, forward
exchange rates and forward margins etc. The determination of cross rates given the
exchange rate for a currency has also been discussed. Finally, we have also
analyzed the factors that determine the forward margin.
Model questions:
1. How foreign exchange rate is determined?
2. What are the factors that determine the foreign exchange rate?
3. Explain the concepts of direct and indirect quotation.
4. Define the concepts spot and forward exchange rates.
5. Explain the need for forward exchange rates and also explain forward
premium and forward discount.
6. Discuss the factors that determine forward margin.
7. Calculate the forward buying and selling rates of euro in terms of rupees for
1 month, 2 months and 3months.
Spot Euro 1 = Rs. 54.4050 ? 54.4060
1 month forward = 250/300
2 months forward= 350/400
3monthsforward=425/475
CHAPTER 2
MERCHANT RATES AND INTER BANK TRANSACTIONS
The objective of this chapter is to introduce the reader the main elements of
merchant transactions and different types of merchant rates quoted by the foreign
exchange dealers. While banks being the authorized dealers in the foreign exchange
market, the discussion in this chapter are also devoted to analyze the various inter-
bank transactions carried out by the banks on behalf of their customers.
Introduction:
Foreign exchange transactions in the foreign exchange market can be
broadly divided into two: 1. Merchant transactions and 2. Inter bank transactions.
While the dealing of a bank with its customer is known as merchant business or
merchant transactions and the rates quoted in such transactions are called
merchant rates`, the foreign exchange transaction between banks are known as
inter bank transactions and the rates quoted in such transactions are known as inter
bank rates`.
When a merchant transaction takes place? The exporter in order to convert
his sale proceeds received in the form of foreign currency into domestic currency
approaches the banker of his country. Similarly, the importer approaches his banker
in his country to convert the domestic currency into foreign currency. Such
transaction also takes place when a resident approaches his bank to convert foreign
currency received by him into home currency and vice versa. In the both the deals
the banks book a profit. These explain the existence of a distinct relationship
between merchant rates and inter bank rates. The prevailing inter bank rate becomes
the basis for merchant rates.
The merchant business in which the contract with the customer to buy or
sell foreign exchange is agreed to and executed on the same day is known as ready
transaction` or cash transaction`. As in the case of inter bank transactions, a value
next day` contract is deliverable on the next business day and a spot contract` is
deliverable on the second succeeding business day following the date of the
contract. Most of the transactions with customers are on ready basis. In practice, the
terms ready` and spot` are used synonymously to refer to transactions concluded
and executed on the same day.
Basis for Merchant Rates:
When the bank buys foreign exchange for the customer, it sells the same in
the inter bank market at better rates and thus makes a profit out of the deal. In the
inter bank market, the bank will accept the rate as dictated by the market. It can
therefore sell foreign exchange in the market at the market buying rate for the
currency concerned. Thus the inter bank buying rate forms the basis for quotation of
buying rate by the bank to its customer. In the same manner, when the bank sells
foreign exchange to the customer, it meets the commitment by purchasing the
required foreign exchange from the inter bank market. It can acquire foreign
exchange from the market at the market selling rate. Therefore, the inter bank
selling rate forms the basis for quotation of selling rate to the customer by the bank.
The inter bank rate on the basis of which the bank quotes its merchant rate is known
as base rate.
Exchange Margin:
When a merchant customer approaches his banker for foreign exchange and
if the bank quotes the base rate to the customer, it makes no profit. On the other
hand, there are administrative costs involved in the transaction. Moreover, the deal
with the customer takes place first and only after acquiring or selling the foreign
exchange from/to the customer, the bank goes to the inter bank market to sell or
acquire the foreign exchange required to cover the deal with the customer. Between
these transactions there will be time gap of say an hour or two and the exchange
rates are fluctuating constantly and by the time the deal with the market is
concluded, the exchange rate might have turned adverse to the bank. Under such
circumstances, to cover the administrative cost, to overcome the exchange
fluctuation and gain some profit on the transaction to the bank sufficient margin
need to be built into the rate. This is done by loading exchange margin to the base
rate. The quantum of margin that is built into the rate is determined by the bank
concerned, keeping with the market trend.
FEDAI has standardized the exchange margin to be charged by the banks
and the banks are free to load margins within the range. The FEDAI fixed margins
are:
1.
TT Purchase rate
0.025% to 0.080%
2.
Bills Purchase rate
0.125% to 0.150%
3.
TT Selling rate
0.125% to 0.150%
4.
Bills selling rate
0.175% to 0.200%
(Over TT selling rate)
Fineness of Quotation:
The exchange rate is quoted upto 4 decimals in multiples of 0.0025. The
quotation is for one unit of foreign currency except in the case of Japanese Yen,
Belgian Franc, Italian Lira, Indonesian Rupiah, Kenyan Shilling, Spanish Peseta
and currencies of Asian Clearing Union countries (Bangladesh Taka, Myanmar
Kyat, Iranian Riyal, Pakistani Rupee and Sri Lankan Rupee) where the quotation is
per 100 units of the foreign currency concerned. Examples of valid quotations are:
USD 1 = Rs. 43.2350
GBP 1 = Rs. 63.3525
EUR 1 = Rs. 43.5000
JPY 100 = Rs. 35.6075
While computing the merchant rates, the calculations can be made upto five
places of decimal and finally rounded off to the nearest multiple of 0.0025. For
example, if rate for US dollar works out to Rs. 43.12446 per dollar, it can be
rounded off to Rs. 43.1250. The rupee amount paid to or received from a customer
on account of exchange transaction should be rounded off to the nearest rupee, i.e.,
up to 49 paise should be ignored and 50 to 99 paise should be rounded off to higher
rupee (Rule 7 of FEDAI).
DIFFERENT MODES OF FOREIGN EXCHANGE REMITTANCES:
The flow of foreign exchange may take the form either moving into the
country as a result of purchase transaction or moving out of the country as a result
of a sale transaction. Either case the remittances could take place through various
forms. The different forms of remittances are ;
1. Demand draft
2. Mail transfer
3. Telegraphic transfer and
4. Personal cheques.
Types of Buying Rates
In a purchase transaction the bank acquires foreign exchange from the
customer and pays him in Indian rupees. Under such circumstances, while some of
the purchase transactions result in the bank acquiring foreign exchange
immediately, some may take time in the acquisition of foreign exchange. Say for
instance, if the bank pays a demand draft drawn on it by its correspondent bank,
there is no delay because the foreign correspondent bank would already have credit
the nostro account of the paying bank while issuing the demand draft. On the other
hand, if the bank purchases an On demand` bill from the customer, it has first to be
sent to the drawee`s place for collection. The bill will be sent to the correspondent
bank for collection. The correspondent bank will present the bill to the drawee. The
nostro account of the bank with its correspondent bank is credited only when the
drawee makes payment against the bill. Suppose this takes 20 days. The bank will
acquire foreign exchange only after 20 days.
Based on the time of realization of foreign exchange by the bank, the bank quotes
two types of buying rates:
(i)
TT Buying Rate, and
(ii)
Bill Buying Rate.
1. TT Buying Rate (TT stands for Telegraphic Transfer)
When there is no delay involved in the realization of foreign exchange by
the bank then the rate applicable in such a transaction is TT Buying rate. In other
words, the banks account with the overseas bank account of the bank would already
have been credited with. In order to arrive at the TT buying rate, the exchange
margin is deducted from the inter bank buying rate.
Though the name implies telegraphic transfer, it is not necessary that the
proceeds of the transaction are received by telegram. Any transaction where no
delay is involved in the bank acquiring the foreign exchange will be done at the TT
rate.
Transactions where TT rate is applied are:
(i)
Payment of demand drafts, mail transfers, telegraphic transfers, etc.
drawn on the bank where bank`s nostro account is already credited;
(ii)
Foreign bills collected. When a foreign bill is taken for collection, the
bank pays the exporter only when the importer pays for the bill and the
bank`s nostro account abroad is credited;
(iii)
Cancellation of foreign exchange sold earlier. For instance, the
purchaser of a bank draft drawn on New York may later request the
bank to cancel the draft and refund the money to him. In such case, the
bank will apply the TT buying rate to determine the rupee amount
payable to the customer.
The method of calculating TT buying rate for foreign exchange to be
purchased for US dollars is given below.
TT Buying Rate
Dollar / Rupee market spot buying rate = Rs. ...............
Less: Exchange margin -- Rs. ..................
TT Buying rate = Rs. ....................
Rounded off to nearest multiple of 0.0025.
2. Bill Buying Rate
When foreign bill is purchased then the rate applicable would be bill buying
rate. Under this, when a bill is purchased, the proceeds will be realized by the bank
after the bill is presented to the drawee at the overseas center. In the case of a
usance bill the proceeds will be realized on the due date of the bill which includes
the transit period and the usance period of the bill.
Let us suppose that a sight bill on London is purchased; the realization will
be after a period of about 20 days (transit period) and the bank would be able to
dispose of the foreign exchange only after this period. Therefore, the rate quoted to
the customer would be based not on the spot rate in the inter bank market, but on
the inter bank rate for 20 days forward. Similarly, if the bill purchased is 30 days
usance bill, then the bill will realize after about 50 days (20 days transit plus 30
days usance bill, period). Therefore, the bank would be able to dispose of foreign
exchange only after 50 days; the rate to the customer would be based on the inter
bank rate for 50 days forward.
It is important in this that while loading the bills buying rate with forward
margin two points need to be taken into account. First, forward margin is normally
available for periods of a calendar month and not for 20 days etc. Secondly, forward
margin may be at a premium or discount. Premium is to be added to the spot rate
and discount should be deducted from it. Since the banks aim is to book profit,
while making calculations, the bank will see that the period for which forward
margin is loaded is beneficial to the bank.
Let us suppose that on 23rd January inter bank quotation for US dollar was
as under:
Spot
USD 1 = Rs. 43.5000/5500
Spot/January
2000/2100
Spot/February
5000/5100
/March
7500/7600
The bank wants to calculate bill buying rate for a sight bill. The transit
period is, say 20 days. The bill will fall due on 12th February. Apparently, the
forward rate relevant is spot/February rate as this is valid for the entire month of
February. However, it should be noted that forward dollar is at premium. The
customer will be getting more rupees per dollar under the forward rate than under
the spot rate. As we have already seen, the forward premium represents the interest
differential. The Spot/February forward premium includes interest differential up to
the last day of February. As this benefit does not fully accrue on 12th February,
when the bill is expected to mature, the bank will not concede premium up to this
month. It will concede premium only up to the last completed month and base its
bill buying rate for dollar on the Spot/January forward rate. [If the bank takes
Spot/February forward premium, the base rate will be Rs.44.0000. By taking only
Spot/January premium, the bank offers only Rs. 43, 7000 per dollar, which is
beneficial to the bank.] In case of a 30 days` usance bill submitted on the same date,
the expected due date (called the notional due date) is 14th March. The bank will
concede premium only up to February. Thus, where the foreign currency is at
premium, while calculating the bill buying rate, the bank will round off the transit
and usance periods to lower month.
Let us assume that on 18th April, the dollar is at discount and the quotation
in the inter bank market is as under:
Spot
USD 1 = Rs. 42.7500/8000
Spot/April
1300/1200
/May
3000/2900
/June
5500/5400
Let us consider an example that the bank is required to quote a rate for
purchasing a sight bill on New York. Transit period is 20 days. The bill will fall due
on 8th May. Since dollar is at discount, forward dollar fetches lesser rupees than
spot dollars. In other words, longer the forward period involved, the bank is able to
get dollar from the customer at cheaper rate. Therefore, the bank will deduct
discount up to May end while quoting for this bill. In case of a usance bill for 30
days, the due date falls on 7th June. The bank will base its rate to the customer on
Spot/June forward rate. Here, the due date of the bill is rounded off to the higher
month, i.e., end of the month in which it falls. Thus, where the foreign currency is at
discount, while calculating the bill buying rate, the bank will round off the transit
and usance periods to higher month.
It is important to keep in mind the rule for loading forward margin in the
bill buying rate : For calculating bill buying rate, if the forward margin is at
premium round off the transit period and usance period to lower month; if the
forward margin is at discount round off the forward margin to the higher month.
In the TT buying rate, the bank would include exchange margin in the rate
quoted to the customer while quoting for purchase of bills also. The margin may be
slightly higher than that for TT buying rate.
It should have been observed that there will be more than one bill rate, each
for a different period of usance of the bill. The method of calculating bill buying
rate is as follows:
Bill Buying Rate
Dollar/Rupee market spot buying rate = Rs. ...............
Add : Forward premium
(For transit and usance; rounded off to lower month)
OR
Less : Forward discount
(For transit and usance : rounded off to higher month) Rs. .................
= Rs. .................
Less: Exchange margin - Rs. .................
Bill buying rate = Rs. .................
Rounded off to the nearest multiple of 0.0025
Recovery of Interest on Bills Purchased:
When the bank buys a bill from the customer, it immediately pays him in
Indian rupees. The bank is entitled to claim interest from the customer from the date
of purchase of the bill till the bill realized and credited to the nostro account of the
bank with correspondent bank abroad.
On the rupee value of the bill purchased, on the date of purchase itself, the
bank should collect separately, by debit to customer`s account, the interest on the
bill up to its anticipated due date (called the notional due date`) comprising:
(i)
the normal transit period;
(ii)
the usance of the bill; and
(iii)
the grace period, if applicable at the place where the bill is drawn
payable.
The normal transit period is the period of transit allowed by FEDAI for bills
drawn on different countries. The rate of interest to be collected will be determined
by the bank concerned subject to the directives of Reserve Bank in this regard.
Interest shall also be rounded off to the nearest rupee.
Interest is calculated by the formula:
Rate value of bill x Rate of Interest x Number of days
100 x 365
For the bill in Example assuming an interest rate of 10% p.a., the interest
recovered on purchase of the bill would be as follows:
4298,750 x 10 x 20 = Rs. 23,555.
100 x 365
Types of Selling Rates:
In a sale transaction when the bank sells foreign exchange and it actually
receives Indian rupees from the customer and parts with foreign currency. The sale
is effected by issuing a payment instrument on the correspondent bank with which it
maintains the nostro account. Immediately on sale, the bank buys the requisite
foreign exchange from the market and gets its nostro account credited with the
amount so that when the payment instrument issued by it is presented to the
correspondent bank it can be honoured by debit to the nostro account. Therefore for
all sales on ready/spot basis to the customer, the bank resorts to the inter bank
market immediately and the base rate is the inter bank spot selling rate. However,
depending upon whether the sale involves handling of documents by the bank or
not, two types of selling rates are quoted in India. They are:
(i)
TT selling rate ; and
(ii)
Bills selling rate.
1. TT Selling Rate
This is the rate applicable for all transactions which do not involve handling
of documents by the bank.
Transactions for which this rate is quoted are:
(i)
Issue of demand drafts, mail transfers, telegraphic transfers, etc.,
other than for retirement of an import bill ; and
(ii) Payment made for an import transaction where documents were
received directly by the importer;
(iii) Cancellation of a purchase transaction.
The TT selling rate to the customer is calculated on the basis of inter bank
selling rate by adding exchange margin to the inter bank rate.
2. Bills Selling Rate
This rate is to be used for all transactions which involve handling of
documents by the bank: for example, payment against import bills.
This bills selling rate is calculated by adding exchange margin to the TT
selling rate. That means the exchange margin enters into the bills selling rate twice,
once on the inter bank rate and again on the TT selling rate.
The method of calculating selling rate is given below:
Selling Rates
(TT and Bills Selling)
Dollar / Rupee market spot selling rate = Rs. ...............
Add : Exchange margin for TT selling rate + Rs. ..................
TT Buying rate = Rs.
....................
Add : Exchange margin for Bills selling rate + Rs. .................
Bills Selling Rate = Rs. ..............
Rounded off to nearest multiple of 0.0025 and quoted to customer.
Some aspects of exchange quotation
Spread Between TT Rates:
While making exchange quotations the banks have the discretion to include
the exchange margin at rates determined by them. However, that the maximum
spread between TT buying and TT selling rates quoted to the customers shall be as
follows:
Name of Currency
Current maximum spread between
customer rates for TT buying and TT
selling from the mean TT rate
(taking both sides together)
(i) US dollar
1 %
(ii) Pound sterling, Deutsche mark,
2 %
Japanese yen, French franc,
Swiss franc, Dutch guilder and
Australian dollar
(iii) Other currencies
No limit at present, but banks shall keep
the rate spread to the minimum.
The banks are; however, free to quote to customers which are better than
those warranted by the spread limits.
Let us call the currency (other than US dollar) for which the exchange rate is
calculated Calculation of ready rates as the foreign currency`. Suppose a customer
tenders a foreign current bill for purchase by the bank. We have seen in the last
chapter that when customer tenders a dollar bill, the bank disposes of the dollar
acquired from customer in the inter bank market at the market buying rate and
therefore inter bank buying rate for dollar forms the basis for quoting dollar buying
rate the customer. In the case of a foreign currency being tendered by the customer
bank should first get foreign currency converted to US dollar in the international
market. In other words, it has to buy dollars in the international market against
foreign currency. The bank can do so at the market selling rate for dollar. Therefore
the merchant rate for the foreign currency would be calculated by crossing the
dollar selling rate against the foreign currency in the international market and dollar
buying rate against rupee in the inter bank market. The method of calculating ready
rates thus is tabulated below.
TT Buying Rate
Dollar / Rupee market spot buying rate = Rs. ...............
Less : Exchange margin - Rs. ..................
TT Buying rate for dollar = Rs. ....................
Dollar/Foreign Currency market spot selling rate = FC .................
TT buying rate for Foreign Currency = (1) divided by (2) = Rs. ..............
Rounded off to nearest multiple of 0.0025.
Bill Buying Rate
Dollar/Rupee market spot buying rate Rs. .............
Add : Forward premium ( for transit and usance
Periods; rounded off to lower month)
OR
Less : Forward discount (for transit and usance
Periods; rounded off to higher month Rs. .............
Less : Exchange margin - Rs. ................
Bill buying rate for dollar = Rs. .............
Dollar/Foreign currency market spot selling rate = FC ............
Add : Forward premium (for transit and usance periods :
Rounded off to higher month)
OR
Less : Forward discount (for transit and usance periods;
Rounded off to lower month) FC .............
= FC ...............
Bill buying rate for foreign currency = (1) Divided by (2) = Rs. ................
(2)
Rounded off to nearest multiple to 0.0025.
Selling Rates
When the bank sells foreign exchange (other than dollar) to the customer, it
has acquired the required foreign currency in the international market by selling
equivalent US dollars. The bank can sell US dollars in the international mark the
market buying rate for US dollars against the foreign currency concerned dollars
required to effect this sale have to be acquired in the inter bank mark the market
selling rate. Therefore, in calculating the merchant selling rate foreign currency the
relevant rates are dollar buying rate against the foreign currency concerned in the
international market and dollar selling rate against rupees the inter bank market.
FORWARD EXCHANGE CONTRACT
In the previous chapter, we have already discussed the forward exchange
rate and the context in which it arises etc. Here our interest is to understand how
the forward exchange rate is entered into and the problems associated with it.
A forward exchange contract is a mechanism by which one can ensure the
value of one currency against another by fixing the rate of exchange in advance for
a transaction expected to take place at a future date. It is a tool to protect the
exporters and importers against exchange risks. The uncertainty about the rate
which would prevail on a future date is known as exchange risk. From the point of
an exporter the exchange risk is that the foreign currency in which the transaction
takes place may depreciate in future and thus the expected realization will be less in
terms of local currency. The importer also faces exchange risks when the
transaction is designated in a foreign currency. In this case the foreign currency may
appreciate and the importer may be compelled to pay an amount more than that was
originally agreed upon in terms of domestic currency.
In the case of forward exchange contract two parties, one being a banker
from one country entering to a contract to buy or sell a fixed amount of foreign
currency on a specified future date or future period at a predetermined rate. The
forward exchange contracts are entered into between a banker and customer or
between two parties.
FEATURES OF FORWARD EXCHANGE CONTRACT
The following are the features of a forward exchange contract. FEDAI has
also laid down certain guidelines defining certain aspects of forward exchange
contract.
a) Parties: There are two parties in a forward exchange contract. They can be,
1) A bank and a customer.
2) Two banks in the same country.
3) Two banks in different countries.
b) Amount: forward exchange contracts are entered into for a definite sum
expressed in foreign currency.
c) Rate: the rate at which the conversation of foreign exchange is to take place
at a future date is agreed upon at the time of signing the forward contract
which is known as the contracted rate and is to be mentioned in the contract.
d) Date of Delivery: Date of delivery in a forward contract means the future
date
on which the delivery of foreign exchange is to take place and is computed
from the spot date or date of contract. However in practice, date of delivery
is computed from the spot date and hence if a forward contract is signed on
30th Oct with spot date as Nov, 2005 for 2months forward. The date of
delivery is Jan 1, 2006.
In India Rule7, FEDAI has laid down certain guidelines regarding
date of delivery under forward contract.
In the case of bills/documents negotiated, purchased or discounted-date of
negotiation, purchase or discount and payment of rupees to customer. In the
case of bills/documents sent for collection, date of payment of rupees to the
customer on realization of bills.
In case of retirement /crystallization of import bills/documents-the date
of retirement /crystallization of liability whichever is earlier.
e) Option period: in India FEDAI under Rule 7 has laid down guidelines for
option period. The option period of delivery in an option forward contract should
be specified as a calendar week that is 1st to 7th, 8th to 15th, 16th to 23rd or 24th to
last working day of the month or a calendar fortnight that is 15th or 16th to last
working day the month. If the fixed date of delivery or the last date in an option
forward contract happens to be a holiday, the delivery shall be effected/delivery
option exercised on the preceding working day.
f) Option of delivery: In all option forward contracts the merchant whether a
buyer or a seller will have the option of delivery.
g) Place of delivery: All contracts shall be understood to read to be delivered
or paid for at the bank and at the named place. That is, the contractual
obligations under a forward exchange contract like delivery of foreign exchange or
payment are to be executed at the specified branch of the bank.
FEDAI GUIDELINES FOR FORWARD CONTRACTS: RULE NO 7
Exchange contracts shall be for definite amount.
Unless date of delivery is fixed and indicated in the contract the option
period of delivery should be specified as calendar week or calendar fortnight
or calendar month.
If the fixed date of delivery or last date of delivery option is a holiday, the
delivery has to be effected on the preceding working day.
Place of delivery is always at the Bank and at the named place.
Option of delivery is always that of the merchant.
The minimum commission is Rs 250 for booking a forward contract.
Minimum charge is Rs 100 for every request of early delivery
extension/cancellation.
Fixed and Option Forward Contracts
Under the fixed forward contract the delivery of foreign exchange should
take place on a specified future date. Then it is known as fixed forward contract`.
Suppose a customer enters into a three months forward contract on 5th January with
his bank to sell Euro 15,000, then the customer would be presenting a bill or any
other instrument on 7th April to the bank for Euro 15,000. The delivery of foreign
exchange cannot take place prior to or later than the determined date.
Though forward exchange is a mechanism wherein the customer tries to
over come the exchange risk, the purpose will be defeated if the delivery of foreign
exchange does not take place exactly on the due date. Practically speaking, it is not
possible for any exporter to determine in advance the precise date on which he will
be tendering export documents for reasons which are internal relating to production.
Besides internal factors relating to production many other external factors also
decide the date on which he is able to complete shipment and present documents to
the bank. More often, what is possible for the exporter is only estimate the probable
date around which he would be able to complete his commitment.
Under such circumstances, just to avoid the difficulty of fixing the exact
date for delivery of foreign exchange, the customer may be given a choice of
delivering the foreign exchange, during a given period of days. Such an
arrangement whereby the customer can sell or buy from the bank foreign exchange
on any day during a given period of time at a predetermined rate of exchange is
known as Option Forward Contract`. The rate at which the deal takes place is the
option forward rate. For example, on 10th June a customer enters into two months
forward sale contract with the bank with option over August. It means the customer
can sell foreign exchange to the bank on any day between 1st August and 31st
August In the example, the period during which the transaction takes place is
known as the Option Period`.
Computation of Forward Exchange Rates
Fixed Forward Contracts:
The method of calculation of forward rates is similar to that of ready rates
discussed earlier. However, in the case of forward rates, the forward margin added
will include the forward period as well besides the transit and usance period. While
selling the forward margin is included only for the forward period.
Calculation of Option Forward Rates
In the case of option forward contract the customer has the freedom to
deliver the foreign exchange on any day during the option period. The bank should
quote a single rate valid for the entire option period. The option rate quoted on
behalf of the customer is based on the inter bank option forward rate, while between
banks the option of delivery under a forward contract rests with the buying bank. To
put it simply, the quotation under option delivery is as follows: for purchase
transactions quote premium for the earliest delivery and for sale transactions quote
premium for latest delivery.
Execution of Forward Contract
A customer under forward contract knows in advance the time and amount
of foreign exchange to be delivered and the customer is bound by this agreement.
There should not be any variation and on the due date of the forward contract the
customer will either deliver or take delivery of the fixed sum of foreign exchange
agreed upon. But, in practice, quite often the delivery under a forward contract may
take place before or after the due date, or delivery of foreign exchange may not take
place at all. The bank generally agrees to these variations provided the customer
agrees to bear the loss, if any, that the bank may have to sustain on account of the
variation.
Though the delivery or take delivery of a fixed sum of foreign exchange
under a forward contract has to take place at the agreed time, quite often this does
not happen and it may either take place before or after the due date agreed upon.
However, the bank generally agrees to these variations provided the customer bears
the loss if any on account of this variation.
Based on the circumstances, the customer may end up in any of the
following ways:
1. Delivery on the due date.
2. Early delivery.
3. Late delivery.
4. Cancellation on the due date.
5. Early cancellation.
6. Late cancellation.
7. Extension on the due date.
8. Early extension.
9. Late extension.
As per the Rule 8 of FEDAI, a request for delivery or cancellation or
extension of the forward contract should be made by the customer on or before its
maturity date. Otherwise a forward contract which remains unutilized after the due
date becomes an overdue contract. Rule 8 of FEDAI stipulates that banks shall
levy a minimum charge of Rs. 100 for every request from a merchant for early
delivery, extension or cancellation of a forward contract. This is in addition to
recovery of actual loss incurred by the bank caused by these changes.
Delivery on Due Date
This is the situation envisaged when the forward contract was entered into.
When the foreign exchange is delivered on the due date, the rate applied for the
transaction would be the rate originally agreed, irrespective of the spot rate
prevailing.
Early Delivery
When a customer requests early delivery of a forward contract, i.e., delivery
before its due date, the bank may accede to the request provided the customer
agrees to bear the loss, if any, that may accrue to the bank.
The various operations involved may be summarized thus:
With Customer
With Market
1 st April (a) Sell forward due June
(b) Buy forward due June
1st May (c) Sell in execution of (a)
(d) Buy spot to accomplish (c)
(e) Sell forward due June, to dispose of
the proceeds of (b)
1st June
(f) Receive delivery under (b)
(g) Deliver proceeds of (f) in execution
of (e)
On 1st May, the bank makes a spot purchase and forward sale of the same
Currency for the same value. The difference between the rate at which the currency
is purchased and sold in a swap deal is the swap difference.
The swap difference may be a swap loss` or swap gain` depending upon
the rates prevailing in the market. If the bank buys high and sells low, the
differences Swap loss recoverable from the customer. It the bank buys low and sells
high, the difference is the swap gain payable to the customer.
On 1st May, the bank receives rupees from the customer on sale of foreign
exchange to him. It pays rupees to the market for the spot purchase made. If the
amount paid exceeds the amount received, the difference represents outlay of funds.
Interest on outlay of funds is recoverable from the customer from the date of early
delivery to the original due date at a rate not lower than the prime lending rate of
the bank concerned.
If the amount received exceeds the amount paid, the difference represents
inflow of funds. At its discretion, the bank may pay interest to the customer of
inflow of funds at the appropriate rate applicable for term deposits for the period for
which the funds remained with it.
Charges for early delivery will comprise of:
(i)
Swap difference;
(ii)
Interest on outlay of funds; and
(iii)
Flat charge (or handling charge) Rs. 100 (minimum).
Important Note: In the deal with its customer the bank is the market maker`
and the transaction is talked of as purchase` or sale` from the bank`s point of view.
When the bank deals with the market, it is assumed that the market is the mark
maker`. Therefore, the market rates are interpreted with the market buying`
selling` the foreign exchange. The bank can buy at the market selling rate and sell
at the market buying rate.
Cancellation/Extension of forward contract
The customer is having the right to cancel a forward contract at any time
during the currency of the contract. The cancellation is governed by Rule 8 of the
FEDAI. The difference between the contracted rate and the rate at which the
cancellation is done shall be recovered or paid to the customer, if the cancellation is
at the request of the customer. Exchange difference not exceeding Rs.50 shall be
ignored. The spot rate is to be applied for cancellation of the forward contract on
due date. The forward rate is to be applied for cancellation before due date. In the
absence of any instruction from the customer, contracts which have matured shall
on the 15th day from the date of maturity be automatically cancelled. If the 15th day
falls on a holiday or Saturday the cancellation will be done on the next succeeding
working day. The customer is liable for recovery of cancellation charges and in no
case the gain is passed on to the customer since the cancellation is done on account
of customer`s default.
The customer may approach the bank for cancellation when the underlying
transaction becomes infractions, or for any other reason he wishes not to execute the
forward contract. If the underlying transaction is likely to take place on a day
subsequent to the maturity of the forward contract already booked, he may seek
extension in the due date of the contract. Such requests for cancellations or
extension can be made by the customer on or before the maturity of the forward
contract.
Cancellation of Forward Contract on Due date
When a forward purchase contract is cancelled on the due date it is taken
that the bank purchases at the rate originally agreed and sells the same back to the
customer at the ready TT rate. The difference between these two rates is recovered
from/paid to the customer. If the purchase rate under the original forward contract is
higher than the ready T.T selling rate the difference is payable to the customer. If it
is lower, the difference is recoverable from the customer. The amounts involved in
purchase and sale of foreign currency are not passed through the customer`s
account. Only the difference is recovered/paid by way of debit/credit to the
customer`s account.
In the same way when a forward sale contract is cancelled it is treated as if
the bank sells at the rate originally agreed and buys back at the ready T.T buying
rate. The difference between these two rates is recovered from/paid to the customer.
Example: A forward sale contract for French francs 2,50,000 for an import
customer on 15th March for delivery on 15th April at Rs.7.0450. The customer
requests for cancellation of the contract on the due date. The following information
are available. French francs were quoted in London foreign exchange market as
under.
Spot USD 1 = FRF 6.0200/0300
1 month 305/325
2 months 710/760
The U.S dollars were quoted in the local inter bank exchange market on the date of
cancellation is as follows.
Spot USD 1 = Rs. 42.2900/2975
Spot/May 3000/3100
Spot/June 6000/6100
Exchange margin required is 0.10%. What will be the cancellation charges payable
by the customer?
Solution: The sale contract will be cancelled at the ready T.T buying rate.
Dollars/rupee market buying rate = Rs. 42.2900
Less exchange margin at 0.10% = Re 0.0423
Rs.42.2477
Dollar/Franc markets spot selling rate = FRF 6.0300
TT buying rate for Franc (42.2477 / 6.0300) = Rs. 7.0062
Rounded off the applicable rate is Rs. 7.0050
Franc sold to customer at = Rs. 7.0450
Now bought from him at Rs. 7.0050
Net amount payable by customer per franc
Re 0.0400
Therefore, at Re.0.0400 per franc, the customer has to pay Rs. 10,000 for FRF 2,
50,000 by including flat charge of Rs.100, on cancellation Rs. 10,100 will be
recovered from the customer.
Early Cancellation of a Forward Contract:
Sometimes the request for cancellation of a forward purchase contract may
come from a customer before the due date. When such requests come from the
customer, it would be cancelled at the forward selling rate prevailing on the date of
cancellation, the due date of this sale contract to synchronize with the due date of
the original forward purchase contract. On the other hand if a forward sale contract
is cancelled earlier than the due date, cancellation would be done at the forward
purchase rate prevailing on that day with due date of the original forward sale
contract.
Extension on Due date
An exporter finds that he is not able to export on the due date but expects to do
so in about two months. An importer is unable to pay on the due date but is
confident of making payment a month later. In both these cases they may approach
their bank with whom they have entered into forward contracts to postpone the due
date of the contract. Such postponement of the date of delivery under a forward
contract is known as the extension of forward contract.
The earlier practice was to extend the contract at the original rate quoted to
the customer and recover from him charges for extension. The reserve bank has
directed that, with effect from16.1.95 when a forward contract is sought to be
extended, it shall be cancelled and rebooked for the new delivery period at the
prevailing exchange rates.
FEDAI has clarified that it would not be necessary to load exchange
margins when both the cancellation and re-booking of forwards contracts are
undertaken simultaneously. However it is observed that banks do include margin for
cancellation and rebooking as in any other case.
Further only a flat charge of Rs.100 (minimum) should be recovered
and not Rs.250 as in the case of booking a new contract.
Overdue Forward Contracts
As we have already seen, the customer has the right to utilize or cancel or
extend the forward contract on or before its due date. No such right exists after the
expiry of the contract.
FEDAI Rule 8 provides that a forward contract which remains overdue with
any instructions from the customer concerned on or before its due date shall on the
15th day from the date of maturity be automatically cancelled by the bank. The
customer remains liable for the exchange difference arising there from but if it
results in profit it need not be passed on to the customer. In case of delivery
subsequent to automatic cancellation the appropriate current rate prevailing on such
delivery shall be applied.
Roll over Forward Contracts
When deferred payment transactions of imports/exports takes place, the
repayment of the installment and interests on foreign currency loans by the
customer requires long term forward cover where the period extends beyond six
months. The bank may enter into forward contract for long terms provided there is
suitable cover is available in the market. However the cover is made available on
roll over basis in which cases the initial contract may be made for a period of six
months and subsequently each deferred installments for the outstanding balance of
forward contract by extending for further periods of six months each. For these
transactions the rules and charges for cancellation / extension of long term forward
contracts are similar to those of other forward contracts.
Inter bank Deals
Foreign exchange transactions involves transaction by a customer with the
bank while inter bank deals refer to purchase and sale of foreign exchange between
banks. In other words, it refers to the foreign exchange dealings of a bank in inter
bank market.
Cover Deals
The banks deal with foreign exchange on behalf of its customers. Purchase
and sale of foreign currency in the market undertaken to acquire or dispose of
foreign exchange required or acquired as a consequence of its dealings with its
customers is known as the cover deal`. In this way that is through cover deal the
bank gets insured against any fluctuation in the exchange rates.
While quoting a rate to the customer the bank is guided by inter bank rate to
which it adds or deducts its margin, and arrives at the rate it quotes to the customer.
For example, if its is buying dollar from the customer special it takes inter bank
buying rate, deducts its exchange margin and quotes the rate. This exercise is done
on the assumption that immediately on purchase from customer the bank would sell
the foreign exchange to inter bank market at market buying rate.
Foreign currency is considered as peculiar commodity with wide
fluctuations price, the bank would like to sell immediately whatever it purchases
and whenever it sells, it immediately tries to purchase so that it meets it is
commitment. The main reason for this is that the bank wants to reduce exchange
risk it faces to the minimum. Otherwise, any adverse change in the rate would affect
its profits.
In the case of spot deals the transaction is quite simple. If the bank
purchased any foreign exchange, it would try to find another customer to whom it
can sell this and thus books profit. In this process the profit would be the maximum
because both buying and selling rates are determined by the bank and the margin
between the rates is the maximum. If it cannot find another customer its sells in
inter bank market where the rate is determined by the market conditions and the
margin is narrower here.
Example: Your dealer in the Dealing Room` sells through an exchange broker in
the local market USD 5, 00,000 delivery spot in cover of a telegraphic transfer from
abroad.Calculate the rupee amount receivable from this sale assuming that US
dollar / Rupees rates are quoted in the local market as under:
Spot
USD 1 = Rs. 42.8000/8500
Brokerage 0.01%
Solution: The bank sells at the market buying rate of Rs. 42.8000.
Rupee amount received on sale of USD 5,00,0000
At Rs. 42.8000
= Rs. 2,14,00,000
Brokerage payable at 0.01%
- Rs.
2,140
Net amount receivable on the deal
= Rs. 2,13,97,860
Example: A customer sold French Francs 10,00,000 value spot to another customer
at Rs. 6.5200 and covered himself in London market on the same day when the
exchange rates were as under:
Spot
USD 1 = FRF 6.5880/5920
Local inter bank market rates for US dollars were:
Spot
USD 1 = Rs. 42.7.../8500
Calculate the cover rate and ascertain the profit or loss in the transaction.
Ignore brokerage on the inter bank transaction.
Solution: The bank covers itself by buying Francs (or selling dollars) from the
London market at market buying rates for dollar. The requisite dollar is acquired in
the local inter bank market at the market selling rate for dollar against rupee.
Dollar/Rupee selling rate
=
Rs.
42.8500
Dollar/Franc buying rate
=
FRF 6.5880
Franc/Rupee cross rate (42.8500 + 6.5880) =
Rs.
6.5042
Franc is sold to customer at
Rs.
6.5200
The sale is covered at
Rs.
6.5042
Profit per Franc sold
=
Rs.
0.0158
Profit on FRF 10,00,000 at Re. 0.0158 per Franc = Rs. 15,800.
Note : This rate has not been rounded off because no transaction is done at
this rate but is calculated only to arrive at the profit.
Trading:
Trading refers to purchase and sale of foreign exchange in the market other
than to cover bank`s transactions with the customers. The purpose may be to gain
on the expected changes in exchange rates. In India the scope for trading, although
still subject to controls, is getting wider the relaxations being made in the exchange
control regulations.
Example : Your forex dealer had entered into a cross currency deal and had
sold USD 5,00,000 against Deutsche Marks at USD 1 = DEM 1.4400 for spot
delivery. However, later during the day, the market became volatile and the dealer
in compliance with his top management`s guidelines had to square up the position
by purchasing USD 5, 00,000 against DEM at the on-going rate. Assuming the spot
rates are as under:
USD 1 = INR 42.4300/4500
and USD 1 = DEM 1.4440/4450
What will be the gain or loss in the transaction? Your answer should be in
rupees. Ignore brokerage.
Solution: To square its position the bank can purchase US dollars against marks at
the market selling rate of DEM 1.4450 per dollar.
DEM acquired on sale of USD 5,00,000 at DEM 1.4400 = DEM 7,20,000
DEM paid on purchase of USD 5,00,000 at DEM 1.4450 = DEM 7,22,500
Loss on combined deal in Marks = DEM 2,500
In terms of rupees the loss would be the rupee outlay required to acquire
DEM 2,500 from the market. The bank sells USD and acquires DEM at the market
USD buying rate of DEM 1.440. The requisite USD it can acquire in the market at
the market selling rate of Rs. 42.4500. The Mark/Rupee cross rate is (42.4500 +
1.4440) Rs. 29.3975.
Loss on the transaction in rupees = Rs. 23.3975 x 2,500 = Rs. 73.494.
Swap Deals:
Swap contracts can be arranged across currencies. Such contracts are known as
currency swaps and can help manage both interest rate and exchange rate risk.
Many financial institutions count the arranging of swaps, both domestic and foreign
currency, as an important line of business. This method is virtually cheaper than
covering by way of forward options. Technically, a currency swap is an exchange
of debt service obligations denominated in one currency for the service in an agreed
upon principal amount of debt denominated in another currency. By swapping their
future cash flow obligations, the counterparties are able to replace cash flows
denominated in one currency with cash flows in a more desired currency.
A swap deal` is a transaction in which the bank buys and sells the specified
foreign currency simultaneously for different maturities. Thus a swap deal may
involve:
(i)
simultaneous purchase of spot and sale of forward or vice verse ; or
(ii)
Simultaneous purchase and sale, both forward but for different
maturities. For instance, the bank may buy one month forward and
sell two months forward. Such a deal is known as forward swap`.
A swap deal should fulfill the following conditions:
There should be simultaneous buying and selling of the same foreign currency of
same value for different maturities; and
(i)
The deal should have been concluded with the distinct understanding
between the banks that it is a swap deal.
A swap deal is done in the market at a difference from the ordinary deals. In
the ordinary deals the following factors enter into the rates:
(i)
The difference between the buying and selling rates ; and
(ii)
The forward margin, i.e., the premium or discount.
In a swap deal the first factor is ignored and both buying and selling are
done at the same rate. Only the forward margin enters into the deal as the swap
difference.
In a swap deal, both purchase and sale are done with the same bank and they
constitute two legs of the same contract. In a swap deal, it does not really matter as
to what is spot rate. What is important is the swap difference which determines the
quantum of net receipt of payment for the bank as a result of the combined deal. But
the spot rate decides the total value in rupees that either of the banks has to deploy
till receipt of forward proceeds on the due date. Therefore, it is expected that the
spot rate is the spot rate ruling in the market. Normally, the buying or selling rate is
taken depending upon whether the spot side is respectively a sale or purchase to the
market-maker. The practice is also to take the average of the buying and selling
rates. However, it is of little consequence whether the purchase or selling or middle
rate is taken as the spot rate
Need for Swap Deals:
Some of the cases where swap deal may become necessary are described
below:
(1)
When the bank enters into a forward deal for a large amount
with the customer and cannot find a suitable forward cover deal in the
market, recourse to swap deal may become necessary.
(2)
Swap may be needed when early delivery or extension of
forward contracts is effected at the request of the customers.
Please see chapter on Execution of Forward Contracts and
Extension of Forward Contract.
(3)
Swap may be carried out to adjust cash position in a
currency. This explained later in the chapter on Exchange
Dealings.
(4)
Swap may also be carried out when the bank is overbought
for certain maturities and oversold for certain other maturities
in a currency.
Swap and Deposit/Investment:
Let us suppose that the bank sells USD 10,000 three months forward,
Instead of covering its position by a forward purchase, the bank may buy from the
market spot dollar and kept the amount in deposit with a bank in New York. The
deposit will be for a period of three months. On maturity, the deposit will be
utilized to meet its forward sale commitment. Such a transaction is known as swap
and deposit`. The bank may resort to this method if the interest rate at New York is
sufficiently higher than that prevailing in the local market. If instead of keeping the
amount in deposit with a New York bank, in the above case, the spot dollar
purchased is invested in some other securities the transaction is known as swap and
investment`.
Currency Arbitrage
Arbitrage traditionally has been defined as the purchase of assets or commodities on
one market for immediate resale on another in order to profit from a price
discrepancy. In recent years however arbitrage has been used to describe a broader
range of activities. The concept of arbitrage is of particular importance in
International finance because so many of the relationships between domestic and
international financial markets, exchange rates, interest rates and inflation rates
depend on arbitrage for their existence. In fact it is the process of arbitrage that
ensures market efficiency.
The purchase of currencies on one market for immediate resale on another in
order to profit from the exchange rate differential is known as currency arbitrage. If
perfect conditions prevail in the market, the exchange rate for a currency should be
the same in all centers. Until recently, the pervasive practice among bank dealers
was to quote all currencies against the US dollar when trading among them. Now,
however, a growing percentage of currency trades don`t involve the dollar. For
example Swiss banks may quote the Euro against Swiss franc, and German banks
may quote pound sterling in terms of Euros. Exchange traders are continually alert
to the possibility of taking advantage, through currency arbitrage transactions, of
exchange rate inconsistencies in different money centers. These transactions involve
buying a currency in one market and selling it in another. Such activities tend to
keep exchange rates uniform in the various markets.
For example, if US dollar is quoted at Rs. 42.4000 in Mumbai, it should be
quoted at the same rate of Rs. 42.4000 at New York. But under imperfect conditions
prevailing, the rates in different centers may be different. Thus at New York Indian
rupees may be quoted at Rs. 42.4800 per dollar. In such a case, it would be
advantageous for a bank in Mumbai to buy US dollars locally and arrange to sell
them at New York. Assuming the operation to involve Rs. 10 lakhs, the profit made
by the bank would be:
At Mumbai US dollars purchased for Rs. 10,00,000 at Rs. 42,4000 would be
(10,00,000 ? 42.4000) USD 23,584.90.
Amount in rupees realized on selling USD 23,584.90 at New York at Rs.
42.4800 would be Rs. 10,01,887.
Therefore, the gross profit made by the bank on the transaction is Rs, 1,887.
The net profit would be after deducting cable charges, etc., incurred for the
transaction.
The purchase and sale of a foreign currency in different centers to take
advantage of the rate differential is known as arbitrage operations`.
When the arbitrage operation involves only two currencies, as in our
illustration, it is known as simple` or direct` arbitrage.
Sometimes the rate differential may involve more than two currencies. For
example, let us say that these rates are prevailing:
Mumbai on New York
Rs. 42.4000
New York on London
USD 1.5100
Mumbai on London
Rs. 64.0600
Based on quotation for dollar in Mumbai and for sterling in New York, the
sterling rate in Mumbai should be Rs. 64,0250 while the prevailing rate is Rs.
64.0600. The bank can buy dollar locally and utilize it in New York to acquire
sterling there. The sterling thus purchased may be disposed of locally. Let us say the
transaction in undertaken for Rs. 10,00,000.
1.
The bank buys dollars for Rs. 10,00,000 at Mumbai. Amount
realized in dollars is (10,00,000 ? 42.4000) USD 23,584.90.
2.
The bank sells USD 23,584.90 at New York and acquires
pound sterling. Amount realized in pound sterling at USD
1.5100 per pound is (23,584.90 ? 1.5100) GBP 15,619.14.
3.
The bank sells GBP 15,619.14 at Bombay at Rs. 64.0600 and
realizes Rs. 10,00,562.
Therefore, the gross profit on the combined transaction is Rs. 562.
Such an arbitrage operation which involves more than two currencies is
known as compound` or indirect` arbitrage.
Currency arbitrage transactions also explain why such profitable
opportunities are fleeting. In the process of taking advantage of an arbitrage
opportunity the buying and selling of currencies tends to move rates in a manner
that eliminates profit opportunity in the future. When profitable arbitrage
opportunities disappear, we say that the no arbitrage condition holds.
Summary and Conclusions:
In this chapter we have introduced the students the major transactions
involved in foreign exchange transactions namely, the merchant transactions and
inter bank transactions. In the process, we have explained the reader the
determination of forward exchange contracts and the rules involved in the
computation of forward exchange contracts. Also discussed is the various ways by
which the banks try to cover the foreign exchange transactions viz., cover deals
swap deals and arbitrage operations etc.
The students are advised to workout problems related to merchant
transactions, forward exchange contracts and inter bank deals to get more insight in
these transactions.
MODEL QUESTIONS:
1)
Your forex dealer had entered into a cross-currency deal in the inter bank
market and bought DEM 5, 00,000 against USD 1=DEM 1.5150for spot delivery.
However, the market turned volatile and therefore he squared up his position by
disposing of Deutschmarks against US dollars at the on-going market rates.
Assuming Deutschmarks were quoted in the market as under:
Spot USD 1= DEM 1.5250/5300
One month forward 1.5200/5250
And if the spot USD 1=Rs.43.6300/6450 in the local inter bank market, what will
be the gain or loss in the transaction?
Your answer should be to the nearest rupee.
2)
ABN-Amro Bank, Amsterdam wants to purchase 15 million rupees against
US dollars for funding their Vostro account. Assuming the inter bank rates are
43.3625/3700, what would be the rate you would quote to the foreign bank? Ignore
exchange margin, brokerage etc. If the deal is struck, what would be the US dollar
amount that would be created to your Vostro account?
3)
Your exchange dealer has an overnight oversold position in US dollars 3
million at Rs.43.6400. The following deals were done by him on the next day:
Purchase Rate
Rupees
USD 10, 00,000 @ 43.6450
USD 15, 00,000 @ 43.65
USD 5, 00,000 @ 43.6375
Find out his position in dollars after these deals and his profit or loss. Ignore
brokerage and telex charges.
4)
You had booked a forward purchase TT covering an export bill for French
francs 5, 00,000 at Rs.6.40 due 25th April and covered yourself for same delivery in
the local inter bank market at Rs. 6.42. However, on 25th March the exporter sought
cancellation of the contract as tenor of the bill is changed.
Assuming the French francs were quoted against US dollars in London
market is under:
Spot USD1=FRF 5.6075/6125
One month forward 90/95
Two month forward 155/170
Three month forward 245/260
And in the local inter bank market US dollars were quoted as under:
Spot USD1= Rs. 35.5825/5900
Spot / April 100/200
/May 300/400
/June 600/700
What will be the cancellation charges, if any, payable by the customer,
bearing in mind that you require?
I. An exchange margin of 0.15%, and
II. A flat charge of Rs.100?
5)
On 2nd August an import customer of your bank requested you to book a
forward contract for J. Yen50 million, when market was as under. Delivery required
September.
USD/Re 35.3875/950 USD JPY 104.20/30
Spot/ August +3/+6 Spot/August 00/01
Spot/ September+5/+10 Spot/September00/03
However, on 31st August customer wants to cancel the same contract.
Market on 31st August is as under:
USD/Re 35.3925/75 USD JPY 105.38/45
Calculate the amount to be recovered /paid to the customer on account of
cancellation taking into account:
0.15% margin to be loaded, and
Cancellation charges to be recovered as per FEDAI.
6)
A customer comes to the bank with a draft for US dollar 10,000 drawn on
the Bank. The Rupee/US dollar inter-bank rate is
Spot USD 1= Rs. 37.70 37.80
Calculate the exchange rate and the rupee equivalent payable to the customer.
Rounding off as per FEDAI rules.
Exchange margin to be loaded is 0.080%.
7)
A customer has approached you to issue a demand draft on New York for
USD 50,000. The ongoing market rate is:
USD1 = Rs. 37.70 37.75
One month forward = Rs 37.90 37.95
Exchange margin to be loaded is 0.150%.
Compute the rate to be quoted to the customer.
8)
An exporter customer has presented 60 days sight documents for USD 1,
50,000 drawn under an irrevocable LC.
The Rupee/USD rate in inter-bank market is as follows:
Spot USD 1 = Rs 37.6050 37.7050
1 month forward = Rs 0.1500 0.1000
2 month forward = Rs 0.2800 0.2000
3 month forward =Rs 0.4000 0.3200
Transit period for the bill is twenty days. Exchange margin is 0.150%. Interest to be
recovered is @ 13%. Calculate the rupee amount payable to the exporter.
9)
What is meant by merchant rates? List some transactions involving
merchant rates?
10)
What are the modes of foreign exchange remittances?
11)
What are the principal types of buying and selling rates? Discuss:
12)
What do you understand by the term, Option forward contract? How
does it differ from fixed forward contract?
13)
Describe how forward rates are calculated:
a) When the forward margin is at premium/discount
b) For fixed forward and option forward contracts
14) Explain the circumstances under which a forward exchange contract can
be cancelled by an authorized dealer?
UNIT IV
FOREX MANAGEMENT AND CURRENCY DERIVATIVES
OBJECTIVES OF UNIT IV
To give broader understanding of the FOREX` and main issues of Forex
Management. This unit gives students an understanding of the various Exchange
Rates and Contracts in Exchange Market. The main objectives of this unit are:-
(i) To provide an overview of various exchange rates.
(ii) To analyse the principle types of merchant rates.
(iii)To analyse exchange contracts and execution of forward contracts
(iv) To evaluate the role of interbank in exchange dealings.
UNIT IV STRUCTURE:
1.
Introduction
1.1
Meanings of Foreign Exchange Market.
1.2
Meanings of Rate of Exchange and Exchange Rate under Different
Monetary Standards.
1.3
Participants in Foreign Exchange Market.
1.4
Quotations in the Interbank Market.
1.5
Meanings of Ready, Spot and Forward Transactions.
1.6
Meanings and Factors of Forward margins/swap points.
1.7
Factors determining spot exchange rates.
1.8
Principle types of ready merchant rates.
1.9
Ready rates based on cross rates.
1.10 Forward Exchange Contract.
1.11 Execution of Forward Contract.
1.12 Cancellation and Extension of Forward Contract.
1.13 Exchange Dealings.
1.14 Interbank Deals.
1.15 Forex Risk Management.
1.16 Summary
1.17 Self-Assessment Questions.
1. Introduction
Foreign exchange refers to the mechanism by which the currency of one
country gets converted into the currency of another country. The term foreign
exchange, broadly speaking, includes bank deposits denominated in a foreign
currency, foreign currency itself (bills and coins), and other short-term claims on
foreigners expressed in foreign currency. For an Indian, foreign currency means any
currency other than Indian currency, As per the Foreign Exchange Regulation Act
of India, foreign exchange means foreign currency and includes (i) all deposits,
credits and cheques, letters or credit and bills of exchange, expressed or drawn in
Indian currency but payable in any foreign currency; and (ii) any instrument
payable, at the option of the drawee or holder thereof or any other party thereto,
either in Indian currency or in foreign currency or partly in one and partly in the
other.
The Foreign Exchange Market is a market where money denominated in one
currency is traded with money denominated in another currency. The need for such
trading arises due to buying and selling of goods, services rendered to foreigners,
investment in short-tem and long-term securities across the international
boundaries, foreign bilateral and multilateral assistance, etc.
The primary function of the foreign exchange market is to facilitate trade
between different countries and to enable investment being made by one country in
another. Therefore a knowledge of foreign exchange market operations and
mechanisms is necessary for any fundamental understanding of international
financial management. This unit concentrate on the major issues of FOREX
MANAGEMENT, namely meaning and operations of Foreign Exchange Market,
Forward Exchange and Spot Exchange Rate, Forward Exchange Contract and
Execution, Dealing Position in Exchange Market, Interbank Dealings and Risk in
Forex Dealings
1.1 Meaning of Foreign Exchange Market
In this section, we shall study about meaning of Foreign Exchange Market.
The foreign exchange market is not confined to any given country or region. There
is no physical place where the participants meet to execute the deals, as we see in
the case of commodity markets or stock exchange market. It is more an informal
arrangement among the banks an d brokers operating in a financial centre,
purchasing and selling currencies connected to each other, by telecommunications
like telex, telephone and a satellite communication network called SWIFT, which is
an abbreviation for Worldwide Interbank Financial Telecommunications. Since it is
a cooperative society, it is called SOCIETY FOR WORLDWIDE INTERBANK
FINANCIAL TELECOMMUNICATIONS (SWIFT). This society is owned by
about 250 banks in Europe and North America and registered as a cooperative
society in Brussels, Belgium. It has got communication network at the international
field, connecting more than 25,000 financial institutions throughout the world. Each
Bank is allotted an identifier code. This system enables the member banks to
transact among themselves very quickly and make international payments. Actually
transmission of message takes only few seconds. In India, the regional processing
centre is at Mumbai.
With improvements in telecommunication systems, the foreign exchange
market in the world has witnessed phenomenal expansion during the last two
decades. Transactions between Mumbai, New York, Tokyo, London and Bonn can
be carried out in a few seconds. The Foreign Exchange Market is the largest
financial market with a daily turn over of around 2 trillion US Dollars. The
wholesale segment of the market refers to the dealings taking place among the
banks. The retail segment refers to the dealings between the banks and customers.
The largest exchange market is London, followed by New York, Tokyo, Zurich and
Franckfurt. In India, the leading foreign exchange market is Mumbai and Kolkatta,
Chennai, Delhi and other centres for foreign exchange dealings. Recently,
Bangalore, Cochin, Ahmedabad and Goa have also emerged as new centres of
foreign exchange market.
1.2 Meanings of Rate of Exchange
The term rate of exchange` expresses the price of one currency in terms of
another. Thus, it indicates the exchange ratio between the currencies of two
countries. Suppose for example, one Indian Rupee is equal to 13 USA Cents. This
implies that in the exchange market, one Indian Rupee will fetch 13 Cents. Just as
the price of a commodity is determined by its demand and supply conditions, the
price of a foreign currency (i.e., the rate of an exchange) is also determined on the
basis of demand and supply of the currency. In fact, the rate of exchange of a
currency will keep on changing in the foreign exchange market, due to changes in
demand and supply conditions of the currency. In this section we shall study about
exchange rate varies under different monetary standards.
Rate of Exchange Under the Gold Standard:
Under the Gold Standard the monetary authorities are committed to a policy
of converting gold into currency and currency into gold. This means, the buying and
selling of fold at a specified fixed price in unlimited quantities will be allowed.
If two countries are on the Gold Standard, the rate of exchange between the
two currencies concerned will be fixed on the basis of par value. This means that
the monetary authorities would first establish gold value of the country`s monetary
unit. This is called par value of the currency, Buying and selling of gold will be
allowed between the two countries. This will establish pars of exchange. The rate at
which the currency units of one country will exchange for the currency units of the
other, would depend upon the quantity and purity of gold represented by each. The
ratio between the quantity of gold represented by the gold represented by the two
units is termed as the mint par of exchange of mint parity. Mint par of exchange or
mint parity is defined as the exact equivalent of the currency unit of one country
expressed in terms of the currency unit of another based upon the weight and
fineness of the metal contained in two coins according to the respective mint
regulations. The mint par of exchange, hence expresses the number of units of one
currency which should legally contain the same amount of pure metal as does
(legally) a given number of units of another currency.
Rate of Exchange Under Managed Paper Standard
When the two countries are on inconvertible paper standard, there is no link
with any metal, gold or silver. As such the rate of exchange is determined on the
basis of demand and supply of foreign currencies. The exact rate of exchange is
mainly influenced by their purchasing power parity. The Purchasing Power Parity.
Theory is associated with Swedish economist Gustav Cassel. The theory states that
where the exchange rate between two countries is free to move without limit, if
tends to approximate to the point, where each currency will buy as many goods in
the other country`s market as in its own home market.
This can be briefly illustrated by means of an example. Suppose, a bale of
cotton is sold for Rs.500 in India (price in the home-market) and the same bale of
cotton is sold for 10 dollars in USA`s market, then the rate of exchange between
Rupee and Dollar will be 50 Rupees for a Dollar, ignoring transport costs. This
Purchasing Power Parity theory is defective in several respects: (a) Price in the
home-market depends upon price level internally, which will be affected by the
inflationary conditions in the economy. (b) Different types of goods enter into the
international trade to find the rate of exchange will be impossible. (c) The theory
wrongly assumed that changes in price level induce changes in the exchange rate. In
fact, it is the exchange rate that influence the price level; and (d) The theory does
not consider the demand for foreign exchange, reciprocal demand for commodities,
capital movement, etc., which will affect the exchange rate.
Rate of Exchange Under Exchange Control
The term exchange control` refers to the regulation of transactions
involving foreign exchange to relieve pressure on the exchange value of a particular
currency. The exchange control may take any form. In the most extreme form, it
involves maintaining, for an indefinite period, an artificial value of the currency.
This will be entrusted with the Central Banking authority, which will administer the
exchange control legislations. In such a situation, the rate of exchange is not
determined on the basis of demand and supply forces, but is fixed arbitrarily by the
central authorities. To maintain that rate, all the citizens of the country are
compelled to surrender foreign exchange to the Central Authorities at specified
rates, and then the proceeds will be rationed among those who are in need of foreign
exchange on the basis of priorities.
1.3 Participants in foreign Exchange Market
The following are institutions participants in the Foreign Exchange market.
(a) Corporates
(a) Commercial Banks
(b) Exchange Brokers; and
(c) Central Banks.
Big business houses, International investors and Multinational Corporations
may operate in the foreign exchange market, either for meeting their genuine trade
requirements or investments or for purposes of speculation. They may buy or sell
currencies, with a view to speculate with in the framework of foreign exchange
regulations.
Commercial Banks are the major operators in the foreign exchange market.
They buy and sell currencies on behalf of their customers. They can also operate on
their own initiative. For transactions, involving large volumes, banks may deal
directly among themselves. For smaller transactions, the help of exchange brokers
may be sought. Exchange brokers also facilitate deal between banks. In India, many
deal directly or through recognized exchange brokers. Accredited exchange brokers
are permitted to contract exchange business on behalf of authorized dealers in
foreign exchange and these exchange brokers will have to conform to the rates,.
Rules and regulations and conditions laid down by the FEDAL.
Regarding Central Bank of a country, the intervention will be very rare in
the foreign exchange market. The Central Bank will intervene just to influence the
foreign exchange rate. In India, the Reserve Bank of India does not enter into the
market in the ordinary course. When exchange rates are moving in a detrimental
way, due to unprecedented speculative activities, the RBI may intervene in the
market either directly or through the State bank of India.
1.4 Quotations in the Interbank Market
Generally, a dealer in the Interbank Market will not reveal whether he is
going to buy or sell the foreign exchange. Hence, in the market the quotation made
will be a two-way quotation. This means the market maker will indicate two prices.
One price for buying the currency and the other price for selling the currency. For
example a Mumbai bank may quote the rate of dollar as follows;
USD 1
=
49.1625/1750
What does this mean? The market maker is willing to buy foreign exchange
US dollar at the rate of 49.1625 rupees; and he is willing to sell at the rate of
49.1750 rupees per dollar. In actual practice, while quoting, they will not give the
whole number Rs.49 as every operator will be knowing the big number`. Hence the
quotation will be as follows;
USD 1
=
1625/1750
From this, it is evident that the market maker wants to make a profit of
Rs.0.0125 in the deal of buying and selling one dollar. This quotation is a direct
quotations, and the bank will apply the rule Buy Low; Sell High.
In indirect quotation the Mumbai market maker will quote the rate of dollars
as follows:
Rs.100
=
USD 2.0762/0767
In indirect quotation, the quantity of foreign currency is stated in terms of
per unit of home currency. In this case the market maker will receive 2.0767 USD
per Rs.100/- while buying dollars and give away 2.0762 USD per Rs.100/- while
selling dollar. Therefore he will apply the principle in indirection quotation, Buy
High; Sell Low.
The banker, while dealing with the customer will apply the same principle,
as noted earlier, by adding exchange margin. The buying rate is generally known as
bid rate; and the selling rate is known as the Offer rate`. The difference between
these two rates are the gross profit for the bank and is known as the Spread`.
1.5 Meaning of Ready, Spot and Forward Transaction
In the case of foreign exchange, there is the element of time between
striking the deal and the transaction of the actual deal. The Transaction in the
interbank market take for the settlement either (a) on the same day itself; or (b) it
may take two days later; or (c) it may take a longer time, say after a month or two.
Based on the nature of deal, the following are the three transactions are estimated.
Ready Transactions: In cases where the agreement to buy and sell the foreign
exchange takes place and actual settlement is finished (i.e., delivery of foreign
exchange and the receipt of the price, i.e., exchange transaction proper is completed
on that day itself, it is called ready transaction. It is also known as Value today.
Spot Transactions: In some transactions, the deal will be struck; but the actual
exchange of currencies will take place, say, after two days from the date of contract.
This type of transaction is known as Spot Transaction. For example, if the contract
for certain amount of foreign exchange is made on an agreed rate, say on Monday,
the actual delivery, i.e., completion of transaction will take place on Wednesday. If
that day happens to be a holiday, the delivery will take place on the very next day,
i.e., Thursday, it is on this day, the contract is fulfilled by paying rupees and
receiving dollars or vice versa.
Forward Transaction: On the other hand, the deal will be struck on a particular day,
wherein rate will be agreed upon. But the actual transaction will take place at a
specified future date. This is called Forward Transaction. The Forward Transaction
may be for one month, two months or even three months. This means, the actual
contract will take place on a particular day. This forward contract for delivery of
currencies will take place after one month, two months or three months decided
according to the contract.
1.6 Meaning and Factors of Forward Margins/Swap Points
Since the foreign exchange rate will be fluctuation, the spot rate of the
currency will not be the same at a future date, i.e., after one month or so. If the
forward rate and spot rate happen to be the same, then it is called at par. That is
forward rate is at par with spot. This will be very rate in foreign exchange
transactions, unless the currencies in question are steady and stable for a pretty long
time. Generally the forward rate of a currency will be costlier or cheaper than spot
rate. The difference between the spot rate and the forward rate is known as Forward
Margin, otherwise called Swap Points. The forward margin may be either at
premium or at discount. In the former case, the forward rate will be cheaper than the
spot rate. Under direct quotation, premium is added to spot rate to arrive at the
forward rate. This is done for both purchase and sale transaction. Discount is
deducted from the spot rate to arrive at the forward rate.
Factors Determining Forward Margin
In this section, we shall briefly study about the factors that determine the
forward margin.
Rate of Interest
The prevailing rate of interest at home and also in the foreign country from
which we want to get foreign exchange decide the forward margin. To put it shortly,
it depends upon the differences in the rate of interest prevailing at the home centre
and the concerned foreign centre. If the rate of interest at the foreign centre is higher
that the rate of interest prevailing at home centre, naturally, the interest gained by
investing in the foreign centre will be more than the interest gained at home centre.
If the rate of interest at the foreign centre is higher than the home centre, the
forward margin would be at discount. Conversely if the rate of interest is lower in
the foreign centre and higher in the home centre, the forward margin would be at
premium.
Demand and Supply of Foreign Currency
This is similar to the principle of demand and supply of a commodity. If a
particular foreign currency is in great demand than its supply, then, naturally, it will
be costlier and it will be sold at a premium. If the supply exceeds the demand, the
forward rate will be at a discount.
Investment Activities
Another factor influencing forward margin will be due to the hectic
activities of investments, taking advantage of differences in the rate of interest
between one centre and another. The investor may borrow from low interest centre
and invest the amount in the high interest centre. For example, the investor may
borrow at London at the rate of 5% p.a. and invest the amount in Chennai at 12%
p.a. In order to secure his position, he may cover up his transaction in the forward
marker. Then, he will sell spot pound-sterling and buy forward pound-sterling.
When many investors do like this, the supply of spot Pound-Sterling increases
abundantly putting down the price. The demand for forward pound-sterling
increases, pushing up the price.
Speculative Activities Regarding Spot Rates
The forward rates are based on spot rates. Any speculation in the movement
of spot rates would also influence forward rates. If exchange dealers anticipate spot
rate to appreciate, they will quote forward rate at a premium. If they expect the spot
rate to depreciate, the forward rate would be quoted at a discount.
Exchange Regulation
Exchange control regulations may also put restrictions or conditions on the
forward dealing, leading to change in forward margin. Such restrictions may be
with respect to keeping of balances abroad, borrowing overseas etc. If the Central
Bank of the country intervenes in the forward market, this will influence forward
margin.
1.7 Factors Determining Spot Exchange Rates
The most vital factor in foreign exchange is the determination of spot
exchange rate. It is on this, all other activities revolve. We know that forward
margin is determined by adding premium or subtraction discount with reference to
spot rate. The spot exchange rate is not determined by a single factor. It is the
combination of several factors which act either concurrently or independently in
determining the spot rate. Let us discuss about these factors.
Balance of Payments
A study of International Trade and Consequent Balance of Payments
between countries will determine the value of the currencies concerned. We know
that in international trade exports from a country, both visible and invisible
represent the supply side of foreign exchange. On the contrary, imports into a
country, both visible and invisible create demand for foreign exchange. Let us
illustrate with an example. Suppose India is making lot of exports to USA (both
visible and also invisible). The Indian exporters have to receive Rupee` payment
from USA and the importing merchants in USA would be offering lot of US dollars
in exchange for rupees for payment to Indian merchants. Thus, there will be lot of
supply of US dollars from the point of view of India and lost of demand for Indian
rupees from the point of view of USA. Thus exports represent supply of Dollar
demanding Rupees. When there is lot of supply of dollar, demanding rupees, the
value of Rupee will automatically go up. On the other hand, if India imports more,
we have to pay Dollars to USA merchants. This means, we will offer lot of Rupees,
demanding Dollars. In that case, the value of Dollar will go up comparative to
Rupees. In other words Put if differently, the exporters would offer foreign
currencies in the exchange market, they have acquired, and demand local currency
in exchange. Similarly, importers would offer local currency in exchange for
foreign currency.
When a country is continuously importing more than what it exports to the
other country, in the long run, the demand for the currency of the country importing
would be lesser than its supply. This is an indication that the Balance of Payments
of the country with reference to the other country is continuously at deficit. This
will lead to decline of the value of the currency in relation to the other country. On
the other hand if the balance of payments of a country is continuously at surplus, it
is an indication that the demand for the currency in the market is higher than its
supply and therefore the currency gains more value. Thus the value of the currency
depends on balance of payment position.
Inflation in the Economy
Another important factor that would have serious effect on the value of
currencies and the exchange rate is the level of inflation in the country. More
inflation means increase in domestic prices of commodities. When commodities are
priced at a higher level, exports would dwindle, as the price would not be
competitive in the international market, and foreigners would not demand the
commodities at a higher price. The decrease in the export, in the long run, would
reduce the demand for the currency of the country and the external value of the
currency would decline. Thus, if the country is under the grip of more inflation, the
value of the currency will be low in the exchange market.
It should be understood in this context, that the value of the currencies
concerned will depend on comparative inflationary rate in the two countries.
Suppose the inflation in India is 20% and in USA also it 20%, the rate between
dollar and rupee will remain the same. If inflation in India is higher than USA, the
rupee will depreciate in value relative to dollar. Almost all countries of the world
will be experiencing inflation` to a greater or lesser degrees. The inflation is a very
vital factor in deciding the value of the currency.
Interest Rates
The difference in interest rate between countries has great influence in the
short term movement of capital between countries. If the interest rate in country A`
increases, that country would attract short term of founds from other countries. This
will create demand for the currency of the country having higher rate of interest.
Ultimately, this will lead to increase in its exchange value. Raising the interest rate
may also be adopted by a country deliberately to attract foreign investments to
easen tight money conditions. This will increase the value of the currency. This is
also an attempt to reduce the outflow of the country`s currency. But, this process
may not sustain for long, if the other country also adopt similar measures of
increasing the rate of interest. If country B` also increases the interest rate like that
of country A`, there will be no change in the exchange rate and the effect of
country A` will be nullified
Money Supply
Money supply is also another factor affecting the rate of exchange between
countries. As increased money supply will cause inflationary conditions in the
economy and thereby affect the exchange rate via increase in price of exportable
commodities. An increase in money supply should have scope for increasing
production of goods in the economy. In other words, the increase in money supply
should go hand-in-hand with increase in the production of goods in the economy.
Otherwise, the increased money supply will be utilized in the purchase of foreign
commodities and also making foreign investments. Thus the supply of the currency
in the foreign market increases and the value declines. The downward pressure on
the external value of the currency will in its turn increase the cost of imports and
finally it adds to inflation in the economy.
Increase in National Income
Increase in national income of a country indicates an increase in the income
of the residents of the country. This increase will naturally, create demand for goods
in the country. If there is under-utilised productive capacity in the economy, this
demand will lead to increase in production of goods. This will also lead to more
export of goods. In some cases, this adjustment process will take a very long time;
and in some other cases there will not be increased production at all. In such cases
where the production does not increase in sympathy with income rise, it may lead to
increased imports and also increased supply of the currency of the country in the
foreign exchange market. This result is similar to that of inflation, i.e., decline in the
value of the currency. Thus, increase in the national income may lead to increase in
investment or in consumption and accordingly, it will have its effect on the
exchange rate. Here also, this concept of increased national income is related to
relative increase in national income between two countries and not the absolute
increase in national income.
Discoveries of New Resources
A country in its progress of economic development, may also discover new
resources which are very vital for the economy. These resources are called Key
Resources` or Basic Resources` which would abundantly help the economy in the
production of new goods and services and also in reducing the cost of production of
existing goods and services. A country may discover Oil resources which are very
vital for economic development.
Capital Movements
Bright and congenial climate in a country combined with political stability
will encourage portfolio investments in that country. In such cases, there will be
very high demand for the currencies of those countries for purposes of movements.
This higher demand will result in the increase of exchange rate of those currencies.
On the other hand, poor economic outlook, instantly, repatriation of investments
etc. will result in the decreased demand for the currencies of those countries and as
a result the exchange rate of those currencies will fall.
Speculation and Psychological Factors
The speculation may take the form of bull, i.e., purchasing heavily expecting
a rise in price; or it may take the form of bear, i.e., selling heavily expecting a fall in
price. It may also take the form of leads and lags, i.e., changing the time of
settlement of debts with a view to getting advantage of the change in exchange
rates. Arbitrage operations are also undertaken by the speculations to take
advantage of difference in two markets. This will cause movements in exchange
rates in both markets till a level is reached.
Finally, political stability of the country is of very vital factor. Investors will
not be interested in countries which are ravaged with frequent wars or political
rebellion. Frequent election, frequent change of government, frequent changes of
policies of the government, lack of political will on the part of government etc., will
detract the investors, and the currency of the country may not enjoy high value.
1.8 Principle Types of Ready Merchant Rates
The foreign exchange dealing of a bank with its customers is known as
merchant business and the exchange rate at which the transaction takes place is the
merchant rate`. The merchant business in which the contract with the customer to
buy or sell foreign exchange is agreed to and executed on the same day is known as
ready transaction` or cash transaction`. As in the case of interbank transactions, a
value next day` contract is deliverable on the next business day and spot contract`
is deliverable on the second succeeding business day following the date of the
contract. In this section we focus on principle types of buying as well as selling
rates.
Principal Types of Buying Rates
In a purchase transaction the bank acquires foreign exchange from the
customer and pays him in Indian rupees. Some of the purchase transactions result in
the bank acquiring foreign exchange immediately, while some involve delay in the
acquisition of foreign exchange. Depending upon the time of realization of foreign
exchange by the bank, tow types of buying rates are quoted in India. They are:
(i)
TT Buying Rate, and
(ii)
Bill Buying Rate.
TT Buying Rate (TT Stands for Telegraphic Transfer)
This is the rate applied when the transactions does not involve any delay in
realization of the foreign exchange by the bank. In other words, the nostro account
of the bank would already have been credited. The rate is calculated by deducting
from the interbank buying rate the exchange margin as determined by the bank.
Though the name implies telegraphic transfer, it is not necessary that the proceeds
of the transaction are received by telegram. Any transaction where no delay is
involved in the bank acquiring the foreign exchange will be done at the TT rate.
Transactions where TT rate is applied are:
(i)
Payment of demand drafts, mail transfers, telegraphic transfers, etc.
drawn on the bank where bank`s nostro account is already credited;
(ii)
Foreign bills collected. When a foreign bill is taken for collection, the
bank pays the exporter only when the importer pays for the bill and the
bank`s nostro account abroad is credited;
(iii)
Cancellation of foreign exchange sold earlier.
Bill Buying Rate
This is the rate to be applied when a foreign bill is purchased. When a bill is
purchased, the rupee equivalent of the bill value is paid to the exporter immediately.
However, the proceeds will be realized by the bank after the bill is presented to the
drawee at the overseas centre. In the case of a usance bill, the proceeds will be
realized on the due date of the bill which includes the transit period and the usance
period of the bill.
Principal Types of Selling Rates
When bank sells foreign exchange it receives Indian rupees from the
customer and parts with foreign currency. The sale is effected by issuing a payment
instrument on the correspondent bank with which it maintains the nostro account.
Immediately on sale, the bank buys the requisite foreign exchange from the market
and gets its nostro account credited with the amount so that when the payment
instrument issued by it is presented to the correspondent bank and it can be
honoured by debit to the nostro account. Therefore, for all sales on ready/spot basis
to the customer, the bank resorts to the interbank market immediately and the base
rate is the interbank spot selling rate. However, depending upon the work involved,
viz., whether the safe involves handling of documents by the bank or not, two types
of selling rates are quoted in India. They are:
(i)
TT selling rate; and
(ii)
Bills selling rate.
TT Selling Rate
This is the rate to be used for all transactions that do not involve handling of
documents by the bank. Transactions for which this rate is quoted are:
(i)
Issue of demand drafts, mail transfers, telegraphic transfers, etc., other
than for retirement of an import bill; and
(ii)
Cancellation of foreign exchange purchased earlier.
The TT selling rate is calculated on the basis of Interbank selling rate. The
rate to the customer is calculated by adding exchange margin to the interbank rate.
Bills Selling Rate
This rate is to be used for all transactions which involve handling of
documents by the bank: for example, payment against import bills. The bills selling
rate is calculated by adding exchange margin to the TT selling rate. That means the
exchange margin enters into the bills selling rate twice, once on the interbank rate
and again on the TT selling rate.
1.9 Ready Rates Based on Cross Rates
In this section we shall first examine how exchange rates are quoted in
international markets and then we shall see how these rates are used for quoting
rates for currencies other than US dollar in India.
Exchange Quotations in International Markets
In international markets, barring few exceptions, all rates are quoted in
terms of US dollar. For instance, at Singapore Sweets may be quoted at
1.5425/5440 and Japanese Yen at 104.67/70. This should be understood as:
USD 1 = CHF 1.5425 - 1.5440
USD 1 = JPY 104.67 ? 104.70
In interpreting an international market quotation, we may approach from
either the variable currency or the base currency, viz., the dollar. For instance, we
may take a transaction in which Swiss francs are received in exchange for dollars
as: (a) purchase of Swiss francs against Dollar or (b) sale of Dollar against Swiss
francs. For the sake of uniformity we will assume the base currency as the currency
being bought of sold.
The quotation for Swiss franc is CHF 1.5425 and CHF 1.5440 per Dollar.
While buying dollar the quoting bank would part with fewer francs per dollar and
while selling dollars would require as many francs as possible. Thus, CHF 1.5425 is
the dollar buying rate and DEM 1.5440 is the dollar selling rate. It may be observed
that when viewed from dollar, the exchange quotation partakes the character of a
direct quotation and the maxim Buy low; Sell high` is applicable. We will denote
such rates as Dollar/Foreign Currency Rates`, implying that dollar is being bought
or sold against foreign currency.
Few currencies such as pound-sterling and Euro are quoted in variable units
of US dollar. They are quoted as so many US dollars per unit of foreign currency
concerned. Examples are:
GBP 1 = USD 1.4326/4348
EUR 1 = USD 0.9525/9548
The base currency here is the foreign currency. Taking Euro as example, the
quoting bank will buy that currency at USD 0.9525 and sell at USD 0.9548. We will
indicate such quotation as Foreign Currency/Dollar Rate`, the quotation being for
purchase or sale of foreign currency against dollars.
Cross Rates and Chain Rule
Let us now see how exchange rates are calculated in India based on
quotations in international markets.
In India, buying rates are calculated on the assumption that the foreign
exchange acquired is disposed of abroad in the international market and the
proceeds realized in US dollars. The US dollars thus acquired would be sold in the
local interbank market to realize the rupee. For example, if the bank purchased a
CHF 10,000 bill it is assumed that it will sell the Swiss francs at the Singapore
market and acquire US dollars there. The US dollars are then sold in the interbank
market against Indian rupee.
The bank would get the rate for US dollars in terms of Indian rupees in
India. This would be the interbank rate for US dollars. It would also get the rate for
US dollars in terms of Swiss francs at the Singapore market. The bank has to quote
the rate to the customer for Swiss franc in terms of Indian rupees.
The fixing of rate of exchange between the foreign currency and Indian
rupee through the medium of some other currency is done by a method known as
Chain Rule`. The rate thus obtained is the cross rate` between these currencies.
1.10 Forward Exchange Contract
Forward exchange contract is a device which can afford adequate protection
to an importer or an exporter against exchange risk. Under a forward exchange
contract a banker and a customer or another banker enter into a contract to buy or
sell a fixed amount of foreign currency on a specified future date as a predetermined
rate of exchange. Our exporter, for instance, instead of groping in the dark or
making a wild guess about what the future rate would be, enters into a contract with
his banker immediately. He agrees to sell foreign exchange of specified amount and
currency at a specified future date. The banker on his part agrees to buy this at a
specified rate of exchange. The exporter is thus assured of his price in the local
currency. In our example, the exporter may enter into a forward contract with the
bank for 3 months delivery at Rs.49.50. This rate, as on the date of contract, is
known as 3 months forward rate. When the exporter submits his bill under the
contract, the banker would purchase it at the rate of Rs.49.50 irrespective of the spot
rate then prevailing.
Date of Delivery
According to Rule 7 of FEDAI, a forward contract` is deliverable at a
future date, duration of the contract being computed from the spot value date of the
transactions. Thus the 3 months forward contract is booked on 12th February, the
period of two months should commence from 14th February and the forward
contract will fall due on 14th April.
Date of delivery under forward contract will be:
(i)
In case of bills/documents negotiated purchased or discounted: date of
negotiations/purchase/discount and payment of rupees of customers.
(ii)
In case of bills/document sent for collection: date of payment of rupees
to the customer on realisation.
(iii)
In case of retirement/crystallization of import bills/documents: the date
of retirement or crystallization of liability which ever is earlier,
Fixed and Options Forward Contracts
The forward contract under which the delivery of foreign exchange should
take place on a specified future date is known as fixed forward contract. For
instance, if on 5th March a customer enters into a three months forward contract
with his bank to sell GBP 10,000, it means the customer would be presenting a bill
or any other instrument on 7th June to the bank for GBP 10,000. He cannot deliver
foreign exchange prior to or later than the determined date.
We saw that forward exchange to a device by which the customer tries to
cover the exchange risk. The purpose will be defeated if he is unable to deliver
foreign exchange exactly on the due date. In real situation, if is not possible for any
exporter to determine in advance the precise date on which he will be tendering
export documents. Besides internal factors relating to production, many other
external factors also decide the date on which he is able to complete shipment and
present documents to the bank. At the most, the exporter can only estimate the
probable date around which he would be able to complete his commitment.
With a view to eliminating the difficulty in fixing the exact date for delivery
of foreign exchange, the customer may be given a choice of delivering the foreign
exchange during a given period of days. An arrangement whereby the customer can
sell or buy from the bank foreign exchange on any day during a given period of
time at a predetermined rate of exchange is known as Option Forward Contract`.
The rate of which the deal takes place is the option forward rate. For example, on
15th September a customer enters into two months forward sale contract with the
bank with option over November. It means the customer can sell foreign exchange
to the bank on any day between 1st November and 30th November. The period from
1st to 30th November is known as the Option Period`.
Exchange Control Regulations
While booking forward contracts for customers, banks are required to
observe that the exchange control regulations are complied with. Foreign Exchange
Management (Foreign Exchange Derivative Contracts) Regulations, 2000 govern
forward exchange contract in India. The terms and conditions relate to booking,
cancellation, rebooking etc. of forward exchange contracts are given below:
(a) The authorized dealer, through verification of documentary evidence, should
be satisfied about the genuineness of the underlying exposure.
(b) The maturity of the hedge should not exceed the maturity of the underlying
transaction.
(c) The currency of hedge and tenor are left to the choice of the customer.
(d) Where the exact amount of the underlying transaction is not ascertainable
the contract can be booked on the basis of the reasonable estimate.
(e) Foreign currency loans/bonds will be eligible for hedge only after final
approval is accorded by the Reserve bank, where such approval is necessary.
(f) In case of Global Depository Receipts (GDRs), the issue price should have
been finalized.
(g) Substitution of contracts for hedging trade transactions may be permitted by
an authorized dealer on being satisfied with the circumstances under which
such substitution has become necessary.
The operational aspects of the Forward Contract conditions are given below:
1. Forward contracts can be booked for resident customers who are exposed
to exchange risk in respect of genuine transactions permitted under current
regulations.
2. Before entering into a forward contract, it should be ensured that the
customer is in fact, exposed to exchange risk in a permitted currency in the
underlying transaction. The choice of the currency in which the forward
contract is entered into is left to the customer.
3. While booking forward contracts, irrespective of the underlying transaction
being a current account transaction or a capital account transaction, the
bank should verify suitable documents to ensure the authenticity and the
amount of the permitted currency of the underlying transaction.
4. Forward contacts may be booked for exporters/importers, without
production of documents, up to the average of past three years
export/import turnover. However, at any point of time, the outstanding
contracts shall not exceed 25% of eligible limit, subject to a cap of USD
100 million.
5. Forward contract may be booked for the whole or part amount of the
underlying transaction. Ordinarily the maturity of the forward contract
should match that of the underlying transaction.
6. The bank may permit the customer to substitute an import/export order
under a forward contract provided it is satisfied after verifying the
documentary evidence that a genuine exposure to the extent of the amount
of the original forward contract subsists under the substituted order.
Booking of Forward Contracts
1. The transactions of booking of forward contract is initiated with the customer
enquiring of his bank the rate at which the required forward currency is
available. Before quoting a rate the bank should get details about (i) the
currency, (ii) the period of forward cover, including the particulars of option,
and (iii) the nature and tenor of the instrument.
2. The branch may not be fed with forward rates of all currencies by the
Dealing Room. Even for major currencies forward rates for standard delivery
periods may only to available at the branch.
3. If the rate quoted by the bank is acceptable to the customer, he is required to
submit an application to the bank along with documentary evidence to
support the application, such as the sale contract.
4. After verification of the application and the documentary evidence
submitted, the bank prepares a Forward Exchange Contract`.
5. While preparing the contract, the following points are to be noted:
(a)
The branch may give a serial number to the contract, so that further
reference to if becomes easy.
(b)
Contracts must state the first and last dates of delivery. It is not
permissible to state in contracts delivery one week` or delivery one
month` or delivery three months forward`, etc.
(c)
When more than one rate for bills with different delivers are
mentioned, the contract must state the amount and delivery against each
rate.
(d)
No usance option may be stated in any contract for the purchase of
bills. That is, the contract should not give option to the customer to
tender sight bill or in the alternative 30 days bill, etc. It can be either
sight bill or a usance bill of a specified usance as mentioned in the
contract.
(e)
The first portion of the contract is relevant for booking of the
contract. The second portion is used for recording deliveries under the
contract.
(f)
The contract should be complete in all respects.
6. The number of copies of the contract prepared will depend upon the
requirements of the bank. The original of the contract duly signed by the
bank, along with the duplicate, is sent to the customer.
7. The details of the contract are entered are entered in a Forward Contract
Register. The resister also provides for recording of details of documentary
evidence verified.
8. The documents are verified and marked with the bank stamp and signature of
the bank official, after entering the particulars of the forward contract
booked. It is returned to the customer.
9. The due date of the contract should be diarised in a regular and followed up
on the due date.
10. Charges for booking the forward contract as prescribed by the bank
concerned is recovered from the customer.
11. When the customer delivers foreign exchange on the due date, the
transactions is done at the rate agreed.
Calculation of Fixed Forward Rates
The method of calculation of forward rates is similar to that for ready rates.
The only difference is that in the case of forward rates, the forward margin that is
included in the rate will be for forward period as well. That is, the forward discount
of the forward premium included in the buying rate will be not only for the transit
period and usance, but also for the forward period. For instance, if the bank buys a
30 days sight bill for 2 months forward, the total forward discount will be for (30
days usance + 25 days transit +2 months forward, rounded off to higher month) 4
months.
For selling rates, forward margin is not considered while calculating ready
rates. In the case of forward rates, the forward margin for the forward period will be
included. In other respects, the calculation is same as that of ready rates.
The method of calculation of forward rates is shown below. For TT buying
rate, forward margin will be included only for forward period.
Format for Calculation of Forward buying rate for Dollar
Dollar/Rupee market spot buying rate =Rs. ....
Add : Forward premium (for forward period, transit
Period and usance period: rounded off to lower
Month)
OR
Less : Forward discount (for forward period, transit
Period and usance period: rounded off to higher
Month) ? Rs. ....
Less : Exchange Margin = Rs. ....
Forward buying rate for dollar - Rs. ....
*Rounded off to nearest multiple of 0.0025. = Rs. .... ....(1)
Format for Calculation of Forward Selling Rate
Dollar/Rupee market spot selling rate = Rs. ....
Add : Forward premium (for forward period)
OR
Less : Forward discount (for forward period) ? Rs. ....
= Rs. ....
Add : Exchange Margin to TT selling rate + Rs. ....
Forward TT selling rate for dollar = Rs. ....* ..(1)
Add : Exchange margin for selling rate + Rs. ....
Forward bills selling rate for dollar = Rs. ....* ..(2)
*Rounded off to measure multiple of 0.0025 when quoted to customer
Calculation option forward rates
Under an option forward contract the customer has the freedom to deliver
the foreign exchange on any day during the option period. The bank should quote a
single exchange rate valid for the entire option period.
Suppose that the following rates prevail for US dollar on 17th February:
Buying
Selling
Rs. Rs.
Spot
49.45
49.50
Spot/March
0.05
0.06 pm
Spot/April
0.08
0.09 pm
Spot/May
0.11
0.19 pm
(a) In respect of purchase transaction, the forward premium for delivery, March
is 5 paise and for delivery April is 9 paise. The additional premium of 3
paise for April over that for March represent the interest differential for one
month. If a customer requires forward purchase rate for fixed delivery 30th
April, the bank would concede him the premium up to April end, and quote
him the rate of Rs.49.53 per dollar. On the other hand, if the customer wants
to deliver foreign exchange on first April, he is not entitled to the premium
for April. The forward premium for April beginning would be the same as
that for March end. The bank will therefore quote him a rate of Rs.49.50,
inclusive of premium up to March. Suppose the customer requires the bank
to book a forward purchase contract delivery April. It means, the customer
can deliver foreign exchange on any day during April, i.e., 1st April to 30th
April, but the bank should quote a single rate which could be applicable to
any of these days. The bank would play safe and quote the rate of Rs.49.50
(i.e., the rate for March) for an option forward contract with option to the
customer over the entire April.
(b) It may be argued on behalf of the customer that the option forward rate
quoted to him is based on the interbank option forward rate. The bank would
cover itself by entering into a forward sale with the marker with option to
delivery 1st to 30th April, in which case the premium of 8 paise is available
to it.
1.11 Execution of Forward Contract
The foreign exchange may be delivered on the due date as per the forward
contract. Or, the delivery may take place earlier of later than the due date.
Alternatively, the customer may request cancellation of the contract. This request
for cancellation may be made on the due date, before the due date or later than the
due date. Yet another alternative is that the customer may request postponement of
the date of delivery under the forward contract, This request for postponement may
be made on the due date, earlier than the due date or after the due date.
The various possibilities are summarized in the form of a chart below:
FORWARD CONTRACT
Delivery
Cancellation
Extension
Due Date
Early
Late
From chart it is clear that a forward contract may end up in any of the following
ways:
1. Delivery on the due date.
2. Early delivery.
3. Late delivery.
4. Cancellation on the due date.
5. Early cancellation.
6. Late cancellation.
7. Extension on the due date.
8. Early extension.
9. Late extension.
Rule 8 of FEDAI governing this subject stipulates that the request for
delivery, cancellation or extension of the forward contract should be made by the
customer on or before its maturity date. A forward contract which remains
unutilized after the due date becomes an overdue contract. This section deals with
delivery on or before the due date.
Delivery on Due Date
This is the situation envisaged when the forward contract was entered into.
When the foreign exchange is delivered on the due date, the rate applied for the
transaction would be the rate originally agreed, irrespective of the spot rate
prevailing. The following example and solution may explain the practice of delivery
on due date contract.
Example: The bank has entered into a contract of forward purchase of Swiss
Francs 10,000 with a customer at the rate of Rs.32,5000. On the due date, the spot
rate of Rs.32,7600/8200. State the amount that will be credited to the account of the
customer on purchase of the bill.
Solution: The bank would apply the rate of Rs.32,5000 as originally agreed
for purchase of the bill. The amount credited to the account would be Rs.3,25,000.
Example: On 1st March, the bank enters into a forward contract for 2 months
for selling USD at Rs.46,6600. On 1st May, the contract is put through in retirement
of a bill for USD 1,000 drawn on the customer. On this date, the sopt rates are
Rs.49,3100/5600. Calculate the amount that would be debited to the account of the
customer.
Solution: The bank would apply the rate originally agreed upon, i.e.,
Rs.46,6600 and debit the account of the customer with Rs.48,660.
Early Delivery
When a customer requests early delivery of a forward contract, i.e., delivery
before its due date, the bank may accede to the request provided the customer
agrees to bear the loss, if any, that may accrue to the bank.
When the bank entered into a forward sale contract with a customer, it
would have covered its position by entering into a forward purchase contract with
the market for the same amount and for a matching period. For example, suppose
the bank has agreed on 1st April to sell USD 10,000 to the customer delivery June at
the rate of Rs.49,1400. Theoretically, on the same day, i.e., on 1st April, a forward
purchase would be made by the bank with the market for USD 10,000 due June.
The idea is that during June when the contract matures, the bank can realize the
purchase contract and sell it to the customer. Suppose further that the customer
requests that the contract be executed on 1St May itself, the Bank would execute the
contract at the original rate agreed upon. Viz., Rs.49,1400 and recover separately
any loss that it may suffer. Let us study how the loss is computed.
On 1st May the bank can sell US dollars to the customer by buying it from
the market at the spot rate prevailing. But the bank has already entered into a
forward purchase contract with the market due June and it has to meet its
commitment. Therefore, on 1st May, the bank would enter into another forward sale
contract with the market due June and thus be able to dispose of the US dollars
when received under the forward purchase contract.
The various operations involved may be summarized thus:
With Customer
With Market
1st April
(a) Sell forward due June
(b) Buy Forward due June
1st May
(c) Sell in execution of (a)
(d) Buy spot to
accomplish (c)
(e) Sell Forward due
June, to dispose of
the process of (b)
1st June
(f) Receive delivery
under (b)
(g) Deliver proceeds of
(f) in execution of (e)
On 1st May, the bank makes a spot purchase and forward sale of the same
currency for the same value. The difference between the rate at which the currency
is purchased and sold in a swap deal is the swap difference.
The swap difference may be a swap loss` or swap gain` depending upon
the rates prevailing in the market. If the bank buys high and sells low, the
differences is swap loss recoverable from the customer. If the bank buys low and
sells high, the difference is the swap gain payable to the customer.
On 1st May, the bank receives rupees from the customer on sale of foreign
exchange to him. It pays rupees to the market for the spot purchase made. If he
amount paid exceeds the amount received, the difference represents outlay of funds.
Interest on outlay of funds is recoverable from the customer from the date of early
delivery to the original due date at a rate not lower than the prime lending rate of
the bank concerned.
If the amount received exceeds the amount paid, the difference represents
inflow of funds. At its discretion, the bank may pay interest to the customer on
inflow of funds at the appropriate rate applicable for term deposits for the period for
which the funds remained with it.
Charges for early delivery will comprise of:
(a) Swap difference:
(b) Interest on outlay of funds: and
In addition, at its discretion, the bank may levy some processing charges.
1.12 Cancellation and Extension of Forward Contract
The customer may approach the bank for cancellation when the underlying
transactions becomes infructrious, or for any other reason he wishes not to execute
the forward contract. If the underlying transaction is likely to take place on the day
subsequent to the maturity of the forward contract already booked, he may seek
extension in the due date of the contract. Such requests for cancellation or extension
can be made by the customer on or before the maturity of the forward contract.
Cancellation on Due Date
When the forward purchase contract is cancelled on the due date, it is taken
that the bank purchases at the rate originally agreed and sells the same back to the
customer at the ready TT rate. The difference between these two rates is recovered
from/paid to the customer. If the purchase rate under the original forward contract is
higher than the ready TT selling rate, the difference is payable to the customer. If it
is lower, the difference is recoverable from the customer. The amounts involved in
purchase and sale of foreign currency are not passed through the customer`s
account, only the difference is recovered/paid by way of debit/credit to the
customer`s account. In the same way, when a forward sale contract is cancelled it is
treated as if the bank sells at the rate originally agreed and buys back at the ready
T.T. buying rate. The difference between these two rates is recovered from/paid to
the customer.
Early Cancellation
If a forward purchase contract is required to be cancelled by the customer
earlier than the due date it would be cancelled at the forward selling rate prevailing
on the date of cancellation, the due date of this sale contract to synchronise with the
due date of the original forward purchase contract. For example, assume that on 12th
September a three months forward purchase contract is entered into with a customer
for USD 10,000. The due date of the contract is 12th December. On 12th November,
the customer comes to the bank and requires cancellation of the forward contract.
The contract will be cancelled by the bank selling back to the customer USD 10,000
at its Forward TT selling rate for one month. The difference between the rate under
the original forward purchase contract and forward TT selling rate applied on the
date of cancellation is payable/receivable by the customer. If a forward sale contract
is cancelled earlier than the due date, the cancellation would be done at the forward
purchase rate prevailing on that date with due date to fall on the due date of the
original forward sale contract.
Extension on Due Date
An exporter finds that he is not able to export on the due date but expects to
do so in about two months. An importer is unable to pay on the due date but is
confident of making payment a month later. In both these cases, they may approach
their bank with which they have entered into forward contracts to postpone the due
date of the contract. Such postponement of the date of delivery under a forward
contract is known as the extension of forward contract. When a forward contract is
sought to be extended. It shall be cancelled and rebooked for the new delivery
period at the prevailing exchange rates. FEDAI has clarified that it would not be
necessary to load exchange margins when both the cancellation and re-booking of
forward contracts are undertaken simultaneously. However, it is observed that
banks do include margin for cancellation and rebooking as in any other case.
Early Extension
When the request for extension is received earlier to the due date, it would
be cancelled at the relevant forward rate (as in the case of cancellation) and
rebooked at the current rate.
Overdue Forward Contracts
The customer has the right to utilise or cancel or extend the forward contract
on or before its due date. No such right exists after the expiry of the contract.
FEDAI Rule 8 provides that a forward contract which remains overdue
without any instructions form the customer concerned on or before the due date,
shall on the 15th day from the date of maturity be automatically cancelled by the
bank. The customer remains liable for the exchange difference arising therefrom,
but if it results in profit it need not be passed on to the customer. In case of delivery
subsequent to automatic cancellation, the appropriate current rate prevailing on such
delivery shall be applied.
1.13 Exchange Dealings
When the foreign currency denominated assets and liabilities are held, by
the banks or the business concern, two types of risks are faced. Firstly, the risk that
the exchange rates may vary and the change may affect the cash flows/profits. This
is known as exchange risk. Secondly, the interest rate may vary and it may affect
the cost of holding the foreign currency assets and liabilities. This is known as
interest rate risk. The present section discusses exchange risk management by
banks.
Dealing Position
Foreign exchange is such a sensitive commodity and subject to wide
fluctuations in price that the bank which deals in it would like to keep the balance
always near zero, The bank would endeavour to find a suitable buyer wherever it
purchase so as to dispose of the foreign exchange acquired and be free from
exchange risk. Likewise, whenever it sells it tries to cover its position by a
corresponding purchase. But, in practice, it is not possible to march purchase and
sale for each transaction. So the bank tries to match the total purchases of the day to
the day`s total sales. This is done for each foreign currency separately.
If the amount of sales and purchases of a particular foreign currency is
equal, the position of the bank in that currency is said to be square`. If the
purchases exceed sales, then the bank is said to be in overbought` or long`
position. If the sales exceed purchases, then the bank is said to be in oversold` of
short` position. The bank`s endeavour would be to keep its position square. If it is
in overbought or oversold position, it is exposing itself to exchange risk.
There are tow aspects of maintenance of dealing positions. One is the total
of purchase or sale or commitment of the bank to purchase or sell, irrespective of
the fact whether actual delivery has taken place or not. This is known as the
exchange position. The other is the actual balance in the bank`s account with its
correspondent abroad, as a result of the purchase or sale made by the bank. This is
known as the cash position.
Exchange Position
Exchange position is the new balance of the aggregate purchases and sales
made by the bank in particular currency. This is thus an overall position of the bank
in a particular currency. All purchases and sales whether spot or forward are
included in computing the exchange position. All transactions for, which the bank
has agreed for a firm rate with the counterparty are entered into the exchange
position when this commitment is made. Therefore, in the case of forward contracts,
they will enter into the exchange position on the date the contract with the customer
is concluded. The actual date of delivery is not considered here. All purchases add
to the balance and all sales reduce the balance.
The exchange position is worked out every day so as to ascertain the
position of the bank in that particular currency. Based on the position arrived at,
remedial measures as are needed may be taken. For example, if the bank finds that
it is oversold to the extent of USD 25,000. It may arrange to buy this amount from
the interbank market. Whether this purchase will be spot or forward will depend
upon the cash position. If the bank has commitment of deliver foreign exchange
soon, but it has no sufficient balance in the nostro account abroad, it may purchase
spot. If the bank has no immediate requirement of foreign exchange, it may buy it
forward.
Examples of sources for the bank for purchase of foreign currency are:
(i) Payment of DD, MT, TT, travellers cheques, etc.
(ii) Purchase of bills,
(iii)Purchase of other instruments like cheques.
(iv) Forward purchase contracts (entered to the postion of the date of contracts).
(v) Realisation of bills sent for collection.
(vi) Purchase in interbank/international markets.
Examples of avenues of sale are:
(i) Issue of DD, MT, TT, travelers cheques, etc.
(ii) Payments of bills drawn on customers.
(iii)Forward sale contract (entered in the position on the date of contracts).
(iv) Sale to interbank/international markets.
Exchange position is also k now as dealing position`.
Cash Position
Cash position is the balance outstanding in the bank`s nostro account
abroad. The stock of foreign currency is held by the bank in the form of balances
with correspondent bank in the foreign centre concerned. All foreign exchange
dealings of the bank are routed through these nostro accounts. For example, an
Indian bank will have an account with Bank of America in New York. If the bank is
requested to issue a demand draft in Us dollars. It will issue the draft on Bank of
America, New York. On presentation at New York the bank`s account with Bank of
America will be debited. Likewise, when the bank purchase a bill in US dollars, it
will be sent for collection to Bank of America. Alternatively, the bill may be sent to
another bank in the USA, with instructions to remit proceeds of the bill are credited,
on realisation, to the bank`s account with Bank of America. The purchase of foreign
exchange by the bank in India increases the balance and sale of foreign exchange
reduces the balance in the bank`s account with its correspondent bank abroad.
1.14 Interbank Deals
Interbank deals refer to purchase and sale of foreign exchange between the
banks. In other words it refers to the foreign exchange dealings of a bank in the
interbank market. The main features of interbank deals are given in this section.
Cover Deals
Purchase and sale of foreign currency in the market undertaken to acquire or
dispose of foreign exchange required or acquired as a consequence of the dealings
with its customers is known as the cover deal`. The purpose of cover deal is to
insure the bank against my fluctuation in the exchange rates.
Since the foreign currency is a peculiar commodity with wide fluctuations in
price, the bank would like to sell immediately whatever it purchases and whenever
it sells it goes to the market and makes an immediate purchase to meet its
commitment. In other words, the bank would like to keep its stock of foreign
exchange near zero. The main reason for this is that the bank wants to reduce the
exchange risk it faces to the minimum. Otherwise, any adverse change in the rates
would affect its profits.
Trading
Trading refers to purchase and sale of foreign exchange in the market other
than to cover bank`s transactions with the customers. The purpose may be to gain
on the expected changes in exchange rates.
Funding of Nostro Account
Funding of nostro account of the bank is done by realization of foreign
exchange in the relevant currency purchased by the bank. If sales exceed purchase
to avoid overdraft in the nostro account, the bank would purchase the requisite
foreign exchange in the interbank market and arrange for its credit to the nostro
account
Some of the foreign banks who maintain nostro accounts with the bank may
fund the account by arranging remittance through some other bank. Or the foreign
bank concerned may request the Indian Bank to credit its rupee account and in
compensation credit the account of the Indian bank with it. When required to quote
a rate for this transaction, the bank in India, would quote the rate at which it could
dispose of the foreign exchange in India, viz., the market buying rate. Exchange
margin may not be taken for such transactions.
Swap Deals
A swap deal` is a transaction in which the bank buys and sells the specified
foreign currency simultaneously for different maturities. Thus a swap deal may
involve:
(i) Simultaneously purchase of spot and sage of forward or vice versa; or
(ii) Simultaneously purchase and sale, both forward but for different maturities,
For Instance, the bank may buy one month forward and sell two months
forward. Such a deal is known as forward to forward swap`
To be precise, a deal should fulfil the following conditions to be called a
swap deal:
(i) There should be simultaneous buying and selling of the same foreign
currency of same value for different maturities; and
(ii) The deal should have been concluded with the distinct understanding
between the banks that it is a swap deal.
A swap deal is done in the market at a difference form the ordinary deals. In
the ordinary deals, the following factors enter into the rates;
(i) The difference between the buying and selling rates; and
(ii) The forward margin. i.e., the premium or discount.
In a swap deal, the first factor is ignored and both buying and selling are
done at the snow rate. Only the forward margin enters into the deal same as the
swap difference.
Arbitrage Operations
If perfect conditions prevail in the market, the exchange rate for a currency
should be the same in all centres. For example, if US dollar is quoted at Rs.49,4000
in Mumbai, it should be quoted at the same rate of Rs. 49,4000 at New York. But
under imperfect conditions prevailing, the rates in different centres may be
different. Thus at New York Indian rupees may be quoted at Rs.49,4800 per dollar.
In such a case, it would be advantageous for a bank in Mumbai to buy US dollars
locally and arranged to sell them in New York. Assuming the operations to involve
Rs.10 lakhs the profit made by the bank would be:
At Mumbai US dollars purchased for Rs.10,00,000 at Rs.49,4000 would be
(10,00,000 ? 49,4000) USD 20,242.9). Amount in rupees realized on selling USD
20,242.91 at New York at Rs.49.4800 would be Rs.10,0,.619. Therefore, the gross
profit made by the bank on the transactions is Rs.1,619. The new profit would be
after deducting cable charges, etc., incurred for the transactions.
The purchase
and sale of a foreign currency in different centres to take advantage of the rate
differential is known as arbitrage operations`. When the arbitrage operations
involves only two currencies, as in our illustrations, it is known as simple` or
direct` arbitrage.
1.15 Forex Risk Management
The following are the major risks in foreign exchange dealings
(a) Open Position Risk
(b) Cash Balance Risk
(c) Maturity Mismatches Risk
(d) Credit Risk
(e) Country Risk
(f) Overtrading Risk
(g) Fraud Risk, and
(h) Operational Risks
Open Position Risk
The open position risk or the position risk refers to the risk of change in
exchange rates affecting the overbought or oversold position in foreign currency
held by a bank. Hence, this can also be called the rate risk. The risk can be avoided
by keeping the position in foreign exchange square. The open position in a foreign
currency becomes inevitable for the following reasons:
(a) The dealing room may not obtain reports of all purchases of foreign
currencies made by branches on the same day.
(b) The imbalance may be because the bank is not able to carry out the cover
operation in the interbank market.
(c) Sometimes the imbalance is deliberate. The dealer may foresee that the
foreign currency concerned may strengthen.
Cash Balance Risk
Cash balance refers to actual balances maintained in the nostro accounts at
the end-of each day. Balances in nostro accounts do not earn interest: while any
overdraft involves payment of interest. The endeavour should, therefore, be to keep
the minimum required balance in the nostro accounts. However, perfection on the
count is not possible. Depending upon the requirement for a single currency more
than one nostro account may be maintained. Each of these accounts is operated by a
large number of branches. Communication delays from branches to the dealer or
from the foreign bank to the dealer may result in distortions.
Maturity Mismatches Risk
This risk arises on account of the maturity period of purchase and sale
contracts in a foreign currency not coinciding or matching. The cash flows from
purchases and sales mismatch thereby leaving a gap at the end of each period.
Therefore, this risk is also known as liquidity risk or gap risk
Mismatches in position may arise out of the following reasons:
(i) Under forward contracts, the customers may exercise their option on any
day during the month which may not match with the option under the cover
contract with the market with maturity towards the month end.
(ii) Non-availability of matching forward cover in the market for the volume
and maturity desired.
(iii) Small value of merchant contracts may not aggregative to the round sums
for which cover contracts are available.
(iv) In the interbank contracts, the buyer bank may pick up the contract on any
day during the option period.
(v) Mismatch may deliberately created to minimise swap costs or to take
advantage of changes in interest differential or the large swings in the
demand for spot and near forward currencies.
Credit Risk
Credit Risk is the risk of failure of the counterparty to the contract Credit
risk as classified into (a) contract risk and (b) clean risk.
Contract Risk: arises when the failure of the counterparty is known to the bank
before it executes its part of the contract. Here the bank also refrains from the
contract. The loss to the bank is the loss arising out of exchange rate difference that
may arise when the bank has to cover the gap arising from failure of the contract.
Clean Risk Arises when: the bank has executed the contract, but the counterparty
does not. The loss to the bank in this case is not only the exchange difference, but
the entire amount already deployed. This arises, because, due to time zone
differences between different centres, one currently is paid before the other is
received.
Country Risk
Also known as sovereign risk` or transfer risk`, country risk relates to the
ability and willingness of a country to service its external liabilities. It refers to the
possibility that the government as well other borrowers of a particular country may
be unable to fulfil the obligations under foreign exchange transactions due to
reasons which are beyond the usual credit risks. For example, an importer might
have paid for the import, but due to moratorium imposed by the government, the
amount may not be repatriated.
Overtrading Risk
A bank runs the risk of overtrading if the volume of transactions indulged by
it is beyond its administrative and financial capacity. In the anxiety to earn large
profits, the dealer or the bank may take up large deals, which a normal prudent bank
would have avoided. The deals may take speculative tendencies leading to huge
losses. Viewed from another angle, other operators in the market would find that the
counterparty limit for the bank is exceeded and quote further transactions at higher
premium. Expenses may increase at a faster rate than the earnings. There is,
therefore, a need to restrict the dealings to prudent limits. The tendency to
overtrading is controlled by fixing the following limits:
(a) A limit on the total value of all outstanding forward contracts; and
(b) A limit on the daily transaction value for all currencies together (turnover
limit).
Fraud Risk
Frauds may be indulged in by the dealers or by other operational staff for
personal gains or to conceal a genuine mistake committed earlier. Frauds may take
the form of the dealings for one`s own benefit without putting them through the
bank accounts. Undertaking unnecessary deals to pass on brokerage for a kick back,
sharing benefits by quoting unduly better rates to some banks and customers, etc.
The following procedural measures are taken to avoid frauds:
(a) Separation of dealing form back-up and accounting functions.
(b) On-going auditing, monitoring of positions, etc., to ensure compliance with
procedures.
(c) Regular follow-up of deal slips and contract confirmations.
(d) Regular reconciliation of nostro balances and prompt follow-up
unreconciled items.
(e) Scrutiny of branch reports and pipe-line transactions.
(f) Maintenance of up-to records of currency position, exchange position and
counterparty registers, etc.
Operational Risk
These risks include inadvertent mistakes in the rates, amounts and
counterparties of deals, misdirection of funds, etc. The reasons may be human
errors or administrative inadequacies. The deals are done over telecommunication
and mistakes may be found only when the written confirmations are received later.
1.16 Summary
Exchange control was introduced in India on September 3, 1939 on the
outbreak of the Second World War by virtue of the emergency powers derived
under the financial provisions of the Defence of India Rules, mainly to conserve the
non-sterling area currencies and utilize them for essential purposes. In the closing
stages of the war, it became clear that control over foreign exchange transactions
would have to continue in some form or the other in the post-war period in the
interest of making the most prudent use of the foreign exchange resources. It was,
therefore, decided to place the control on a statutory basis and the Foreign
Exchange Regulations Act of 1947 was enacted.
Over the years, the scope of exchange control in India has steadily widened
and the regulations have become progressively more elaborate with the increasing
foreign exchange outlays under successive Five-year Plans and the relatively
inadequate earnings of foreign exchange. Periodically, appraisals and reviews of
policies and procedures have been undertaken and such modifications made as are
warranted by changes in the national policies and priorities, and fluctuations in the
level of foreign exchange reserves caused by both national and international
economic and other developments. Under these circumstances the Foreign
Exchange Regulations Act, 1973 was passed to replace the Act of 1947.
The Foreign Exchange Regulations Act, 1973 (FERA) was reviewed in
1993 and several amendments were enacted as part of the on-going process of
economic liberalisation relating to foreign investments and foreign trade for closer
interactions with the world economy. At that stage, the Central Government decided
that a further review of the Foreign Exchange Regulations Act would be undertaken
in the light of subsequent development and experience in relation to foreign trade
and investment. A Task Force constituted for this purpose submitted its report in
1994 recommending substantial changes in the existing Act. The Foreign Exchange
Management Act, 1999 was introduced to provide the necessary change.
Foreign Exchange Dealing is a business in which foreign currency is the
commodity. It is understood that exchange rate is not very constant always. Several
factors are contributing to changes in exchange rate in International currency
market. Exchange rates respond quickly to all sort of events. The movement of
exchange rates is the result of the combined effect of a number of factors that are
constantly at play. Among the factors, Economic factors are most fundamentals
which better guides as to how a currency moves in the long run.
Foreign exchange gains and losses are an essential element of doing
business abroad. They are a fact of life for firms engaged in international
transactions. They directly affect a firm`s earnings and cash flow. Therefore, a
firm`s management needs to realize that it can lose more money by neglecting the
foreign exchange affect of international business than it can make by pushing for a
marginal increase in international market penetration and sales.
Foreign exchange is a cost of doing business abroad which the management
requires effective planning and knowledge of foreign exchange contracts like fixed,
forward, spot and other aspects such as exchange fluctuations risk cover scheme,
hedging, speculations, margin rate, currency call options, adjustable peg system,
crawling peg system, managed floating system and interbank operation of foreign
exchange, etc. Therefore a sound knowledge of the different aspect of FOREX is
essential for any export management.
1.17 Self-Assessment Question:-
1. Briefly describe the characteristics of foreign exchange market.
2. What are the factors that determine the exchange rate? Briefly describe the
primary and secondary determinants
3. There are a number of foreign exchange rates. Do you agree? Elaborate.
4. Who are the participants in the foreign exchange market?
5. What is a currency swap`? Can they be used to overcome the exchange rate
fluctuations?
6. What are the various problems faced by a firm when dealing in foreign
exchange related business?
7. Bring out the difference between hedging the speculation.
8. Describe the various foreign currency account schemes available in India. In
what respects do they help to overcome the problems of foreign exchange
available in India?
9. What are forward rate agreements?
10. What is Exchange Rate Forecast? Can we forecast exchange rates?
Reference Books:-
1. International Economics ? Francis Cherunilam
2. International Financial Management ? R.L. Varshney and S. Bhashyam
3. Foreign Exchange : Practice, Concepts and Control ? C.Jeevanandam.
4. Export Marketing ? Cherian and Parab
UNIT---V CURRENCY DERIVATIVES
LESSON -1
Lesson Outline
Introduction
Future Market
Forward Market
Features of Forward Market
Features of Future Market
Currency Future Quotes
Reading Currency Future Quotes
Learning objectives
After reading this lesson you should be able
to
Understand the meaning of future market
The meaning of forward market
The process by which the M.N.Cs manage
their finance
Reading Currency Future Quotes.
Introduction:
World market has expanded many folds in recent years and hence financial
markets had to follow it. Financial markets have come up with many new products
whose popularity has become phenomenal. Growth in terms of trading volumes
particularly for the products ? principally futures and options has been so immense
that it has confused the traditional investors. Though the active markets in futures
and options contracts for physical commodities have existed for many years, these
markets for foreign currencies have only recently attracted this much interest world
wide. This has been experienced over the years that Multinational companies have
been using the spot and forward markets for international transactions. They also
use currency futures, currency options and currency futures options for carious
corporate functions. Interesting point is that while Multinational companies use
them to cover open positions in foreign currencies, the speculators, on the other
hand, trade currencies in these three markets for profit.
Future Contract:
Future contract is normally defined as a standardised agreement with an
organized exchange to buy or sell some item, such as a currency or commodity at a
fixed price at a certain date in the future. Some contracts for example, foreign-
currency futures, provide for cash delivery; others, such as Eurodollar futures, are
based on some reference price and allow only for cash settlement at maturity. The
purpose of futures is not to obtain delivery but to replicate without credit risk, the
gains or losses that would occur from an equivalent forward contract. In principle,
currency futures are similar to foreign-exchange forwards in that they are contracts
for delivery of certain amount of a foreign currency at some future date and at
known price. But in practice, most futures contracts are terminated before maturity.
Before we proceed further it would be good if we understand the Spot and Forward
Foreign exchange rates, because without knowing these, our understanding of the
whole multinational financial system and requirement would remain incomplete.
The Spot and Forward Foreign Exchange Rates:
There are two types of foreign exchange rates, namely the spot rate and
forward rates ruling in the foreign exchange market. The spot rate of exchange
refers to the rate or price in terms of home currency payable for spot delivery of a
specified type of foreign exchange. The forward rate of exchange refers to the price
at which a transaction will be consummated at some specified time in future. In
actual practice there is mot one but many spot rates of exchange; the spot rate for
cables being different from the one applicable to cheques and commercial bills.
In modern times the system of forward rate of foreign exchange has assumed
great importance in affecting the international capital movements and foreign
exchange banks play an important role in this respect by matching the purchases
and sales of forward exchange on the part of would be importers and would be
exporters respectively. The system of forward foreign exchange rate has actually
been developed to minimize risks resulting from the possibility of fluctuations over
time in the spot exchange rate to the importers and exporters. An example would
illustrate this point. Suppose that a radio dealer in India wants to import radios from
England. The foreign exchange rate at the moment is Rs.18 for a pound sterling and
at this rate the Indian radio dealer calculates that he could import the radios, pay the
customs duty on them, sell them in India, pay the sterling price of the radios and
make a profit on them. But by the time the radios have been shipped across the
ocean, exhibited in Mumbai, sold and paid for, several months will have elapsed
and the foreign exchange rate may now be Rs. 20 for a pond-sterling in which case
he has to pay Rs. 2 more for each pound sterling of the price of the radio and in
place of expected profits he may realize actual losses. In other words, the
transaction will be profitable only if the Indian exporter can import radios at an
exchange rate of 18 rupees for a pound sterling.
The forward foreign exchange rate market gives him this assurance. His
band will sell him three months forward pound-sterling at Rs. 18 per pound
sterling by charging a slight premium. That means that the bank undertakes to sell
the named quantity of the pound ?sterling at and exchange rate of Rs. 18 per pound
?sterling in three months time, whatever the rate of exchange in the exchange
market may be when that time comes. Similarly, persons who expect to receive
sums in foreign currency at future dates are able to sell forward exchange to the
banks in order to be sure in advance exactly how much they will receive in terms of
home currency. The basic importance of forward rate of exchange flows from the
fact that actual rate of exchange is liable to fluctuate from time to time and this
renders the purchase and sale of goods abroad risky. Forward exchange rate enables
the exporters and importers of goods to know the prices of their goods which they
are about to export or import.
A Comparision Between Future and Forward Markets:
As a common trend and general preference, it is most unlikely that the
investors would ever involve in the forward market, it is important to understand
some of the attitudes, particularly as a good deal of the literature on pricing futures
contracts typically refers to those contracts interchangeably. Specially differences
resulting from liquidity, credit risk, margin, taxes and commissions could cause
futures and forward contracts not to be priced identically. For example, in dealing
with price risk, futures contracts have several advantages of transaction in
comparision to forward contracts. Sequential spot contracts, which is also known as
spot contracts where the terms of the contract are re negotiated as events unfold, do
not inject any certainty into the transaction. Such a method of contracting is
particularly liable to the hazards of opportunism and may deter investment because
of the relatively high probability that the contract will be breached. But the forward
and futures contracts inject some certainty into their transaction. In both of these,
there is a similarity that the parties agree to perform the terms of the contract at
some future date. Time dated contracts are generally costlier to enforce than spot
contracts. This is so because of the absence of the self enforcing exchange of value
characteristic of spot transactions and the greater uncertainty attached both to the
eventual outcome and each party`s compliance with the term of forward contract.
There are some differences between futures and forward contracts. The
difference is more susceptible to opportunism, especially in their role of reducing
price risk. Forward contracts that cover all feasible contingencies are costly
specified forward contract and this contractual incompleteness will give rise to
enforcement and execution difficulties. Some of the difficulties are listed below:
1. Individuals will have to incur the expense of determining the reliability risk
of the opposite party in the forward contract.
2. Forward contracts are also subject to high enforcement costs where personal
markets are weak.
3. Forward contracts are tied contracts.
Future Contracts
Future contracts allow the price risk to be separated from the reliability risk
by removing the former from the set of factors giving rise to opportunism. The
governance structure supplied by the exchange authority effectively eliminates
reliability risk from future trading. The seller of futures contracts incurs a liability
not to the buyer, but to the clearing house, and likewise the buyer acquires an asset
from the clearing house. The clearing house in effect guarantees all transactions. In
addition, the exchange rules, especially regarding its members` contract, severely
limit their ability to behave opportunistically. Organized exchanges greatly reduce
default and reliability risk from future contracts. This is achieved by transferring
transactions over price risks from a personal to an impersonal market through
standard form futures contracts traded in self-regulated market price.
Future contracts are standard form contracts with only one negotiable term:
price. The standardization of future contracts has significant implications for
transaction costs. This is so for several reasons. First, contracts standardization
eliminates the costs of bargaining over non-price terms and of enforcing contract
provisions. Second, it reduces monitoring costs that are generally incurred in
principal-agent relationships. The principal only needs to give his broker
instructions as to price and quantity which are easily observed. The monitoring
costs in the future market are, therefore, significantly lower than those n the spot
market, where numerous other matters require attention and provide the broker with
opportunities to take advantage of the principal. Third, contract standardization
makes all futures contracts of a particular maturity month perfect substitution. The
fungibility of futures contracts is not a property shared by forward contracts.
The liquidity and competitive nature of future trading also reduce the waiting
costs of brokers and speculators for acceptable bids and offers. The ask-bid, one of
the component of the transaction costs of futures trading is directly correlated with
the search costs of finding acceptable bids and offers. We know in a market with
incomplete information, buyers and sellers will have to search each other out. The
costs of such search activity will differ and will be greater the more geographically
dispersed and heterogeneous are buyers and sellers. The fact is that, the transaction
costs arise because the parties to transactions are different individuals with different
information, divergent motives and mutual suspicions and because expenditure of
resources can reduce the gap in information and protect the parties against each
other. Search costs not only raise the cost of activities but may preclude otherwise
value maximizing transactions from taking place. The market information is
important not only because it reduces waiting costs but also because it ensures that
competitive pressures exist to keep waiting costs to a minimum for any volume of
trade. Since there is competition among the futures traders and hence there is
weeding out effect with excessive search costs and poor forecasting ability. The
large traders make a regular profit whereas small traders make losses since the
performance difficulties occasioned by opportunism raise the cost of transacting.
Each party is confronted with a reliability risk. Reliability risk is an important
source of transaction costs because it will pay individuals to guard against
opportunism and contract breach. Acquiring information on the reliability of those
with whom one transacts yields benefits in the form of reduced losses due to default
and incomplete or inferior performance.
Special Features of Futures and Forward Markets:
FUTURE MARKET:
1. Trading is conducted in a competitive arena by open country of bids,
offers, and amount.
2. Contract terms are standardized with all buyers and sellers negotiating only
with respect to price.
3. Non-member participants deal through brokers.
4. Participants include banks, corporations, financial institutions, individual
investors are speculators.
5. The clearing house of the exchange becomes the opposite side to each
cleared transactions; therefore, the credit risk for a futures market participant
is always the same and there is no need to analyze the credit of other market
participations.
6. Margins deposits are to be required of all participants
7. Settlements are made daily through the exchange clearing house. Gains on
open positions may be withdrawn and losses are collected daily.
8. Long and short positions are usually liquidated easily.
9. Settlements are normally made in cash, with only a small percentage of all
contracts resulting actual delivery.
10. A single, round tip (in and out of the market) commission is charged. It is
negotiated between broker and customer and is relatively small in relation to
the value of the contract.
Forward Market:
1. Trading is done by telex or telephone, with participants generally dealing
directly with broker-dealers.
2. All contract terms are negotiated privately by the parties.
3. Participants deal typically on a principal -to-principal basis.
4. Participants are primarily institutions dealing with one other and other
interested parties dealing through one or more dealers.
5. A participant must examine the credit risk and establish credit limits for
each opposite party.
6. Typically, no money changes hands until delivery, although a small margin
deposit might be required of non dealer customers on certain occasions.
7. Settlement occurs on date agreed upon between the parties to each
transaction.
8. Forward positions are not as easily offset or transferred to other participants.
9. Most transactions result in delivery.
10. No commissions is typically charged if the transaction is made directly with
another dealer. A commission is charged to both buyer and seller, however,
if transacted through a broker.
11. Trading is mostly unregulated.
12. The delivery price is the forward price.
After having distinguished the forward and the future markets it is important to
know the operations in these markets. For this we have to first see that what is
currency quotes and as to how to read the currency future quotes. First of all we will
see that what is meant by currency future quotes.
Currency future quotes can be understood better with the help of the following
table.
Contracts
The face Settlement Change
for Day`s
highest First price of the
traded
at value of price
previous day`s and
lowest day calculated in
the
the
normally
closing price.
prices
U.S.dollars per
Internation
contract
the
last
pound sterling.
al
is
trade used
Monetary
L62,500. for
Market
marking to
market
,
the daily
adjustment
of margin
accounts.
Months
open
High
Low
Settle
Change High
Low
Open
Interest.
Mar
1.4296
1.4346
1.4180 1.4224 -0.052
1.9400 1.4180 41,833
Jun
1.4130
1.4250
1.4090 1.4136 -.0052
1.9100 1.4090 1,377
Sept.
1.4095
1.4125
1.4024 1.4072 -.0050
1.5580 1.4070 136
The above table is a reproduction of currency-futures quotations that is
normally found in most business newspapers. These futures are contracts for
delivery of a standard amount of a foreign currency in exchange for delivery of a
standard amount of a foreign currency in exchange for delivery of a given amount
of U.S. dollars at some future date. The funds to be exchanged may be, for example,
125000Euro in exchange for the equivalent value in dollars. The figure offers a
guideline for interpretation of published future quotations. As in the forward
market, each delivery takes place in the currency of the country, although as a
matter of practice few deliveries actually occur. The futures contract can be used to
hedge, speculate or perform arbitrage in much the same way as forwards are used.
Many commercial and investment banks are members of the major futures
exchanges and are able to buy currencies in the forward market and sell them in the
futures markets, and vice-versa, ensuring that futures prices stay in line with
forward prices for the same delivery date.
Market Operations:
So far as future market operation is concerned, evolution is its feature and
thus a collateral margin that has evolved is to reduce the default risk. As opposed to
margins or stock accounts, a futures margin payment is not a form of down payment
on the balance due since a futures transaction is not an investment of initial capital
in return for a later payoff, but rather in its purest form, is means of gradually
settling the losses and gain on the contract and also as collateral against default.
Margin payments are paid frequently in small amounts relative to the size of the
contract, rather than in one large initial lump sum,. So as to preserve the basic
character of a futures contract as a forward agreement deferred payments for
deferred delivery. In fact, daily cash settlement procedure is an important aspect of
the futures markets, integral in maintaining the trading system. Each of the
transaction requires a good faith deposit known as initial margin, to be posted with
a broker. The minimum amount of initial margin required is set by the exchange
based on the price volatility of the underlying products. The value of a contract
position is assessed, marked to market daily and these changes are settled in cash on
a daily basis. For example, if a contract prices increase, the longs who have
purchased the contract would receive cash equal to the value of gains, while the
shorts-who have sold contracts ?would have to pay in funds equal to the value of
losses. This process is known as variation margin, keeps the value of each market
participants` position current and constitutes to the credit of the futures market.
Initial margin ensures that the participants will pay variation-margin deficit. When
the system is tied with the variation margin vehicle through which daily marks to
market occur, an individual gains the ability of offset a position at any time without
regard to who was initially of the other side of the transaction. This is a key to ease
of trading and confidence in the futures markets. This makes the possibility of
taking a large market position without committing a large amount of capital. For
this reason, futures contracts are considered an extremely highly leveraged
instrument relative to most financial securities. Although high leverage is often
associated with high financial instability and high default risk, futures markets have
a history of financial integrity and low default risk is largely a property of the
intricate, multi-tiered, continually adjusting margining system.
An Illustrative Example:
In order to understand the operation of the futures market, let us take an
imaginary example. Suppose there is an investor who contracts his broker on June
6, 1999 to buy two Nov. 1999 gold futures contracts on the exchange
ABC
Commodity Exchange. Let us again suppose that the current futures price is $500
per ounce. Since the contract size is 100 ounces, the investor has contracted to buy
total of 200 ounces at this price. The broker will require the investor to deposit
funds in what is termed a margin account the amount must be sited at the time the
contract is first entered into is known as the initial margin. We assume this is $2500
per contract of $5,000 in total. At the end of each trading day, the margin account is
adjusted to reflect the investor`s gain or loss. This is known as marking to market
the account.
Suppose by the end of June 6, 1999, the futures price has dropped from $500
to $497. The investor has a loss of 200x$3 or $600. This is because the 200 ounces
of Nov. 1999 gold, which he contracted at $500, cannot be sold for $600 to $4400.
Similarly, if the price of December 1999 gold rose to $503 by the end of the first
day, the balance in the margin account would be increased by $600 to 5600. A trade
is first marked to market at the close of the day on which it takes place. It is then
marked to market at the close of trading on each subsequent day.
Marking to market is not merely an arrangement between broker and client,
however, when there is a $600 decrease in the future prices so that the margin
account of an investor with a long position is reduced by $600, the investor`s broker
has to pay the exchanges $600 the exchange passes the money on the broker of an
investor with a short position. Similarly when there is an increase in the futures
price, brokers for parties with short positions pay money to the exchange and
brokers for parties wit long positions receive money from the exchange.
The investor is entitled to withdraw any balance in the margin account in
excess of the initial margin. In order to ensure that the balance in the margin
account never becomes negative a maintenance margin, which is somewhat lower
than the initial margin, is set. If the balance in the margin account falls below the
maintenance margin, the investor receives a margin call and is expected to top up
the margin account to the initial margin level the next day. In case the extra funds
deposited, known as variation margin, are not provided by the investor, the broker
closes out the position by selling the contract. In the case of the investor considered
earlier, closing out the position would involve underlying the existing contract by
selling 200 ounces of gold for delivery in November 1999.
Clearing House and Clearing Margins:
The trade for an outside party must be executed through a broker, and the
broker must, in turn, trade through a member of the exchange. Normally, the two
patties to a transaction are located far apart and may not even know each other. This
becomes an issue of trust and the question of whether the traders will perform as
they have promised. To overcome of resolve this uncertainty about performance in
accordance with the contract terms, each futures exchange has a clearing house. The
clearing house is a well-capitalized financial institution that guarantees contract
performance to both parties. As soon as the trade is commutated, the clearing house
interposes itself between the buyer and seller. At this point, the original buyer and
seller have obligations to the clearing house and no obligations to each other.
The exchange clearing house calculates the number of contracts on trading on
either a gross or a net basis while calculating clearing margins. The difference
between the current spot price on an asset and corresponding futures prices form the
basis. The gross basis simply adds the total of all long positions entered into by
clients to the total of all short positions entered into by clients. The basis allows
these to be offset against each other. For example, suppose that a clearing house
member has two clients, one with a buy position in 50 countries, the other with a
short position in 30 contracts. Gross margining would calculate the clearing margin
on the basis of 20 contracts. The whole purpose of the margining system is to
reduce the possibility of market participants sustaining losses because of defaults.
Hedging in the Futures Market:
The future market is so sensitive and organized that a single forward contract
can arrange for the precise amount and maturity that the bank`s customer desires. A
single future contract is available only in a predetermined amount for one of the
four maturity dates each year. These two features of the futures market may force
multinational companies to assume some risks of coverage and of currency
fluctuation because they usually need a specified amount of a currency on a
specified date. Still, these risks can he minimized in a properly structured hedge.
Prices in the spot and futures markets move in the same direction by similar
amounts due to arbitrage transactions between these two markets. For example,
suppose on March 1, an English firm imports 5000 Swiss watches at a cost of
250,000 Euros with payment and delivery due on April 1. The Swiss firm, being a
tough negotiator, has demanded that the payment he made in Euro upon the delivery
of the watches. The exchange rates are $0.6667per Euro in the spot market and
$0.6655per Euro in the futures market for delivery on March 15.
Given the costs of marketing the watches, the importer decides that the futures
exchange rate is low enough of the company to purchase them and make a profit on
the transaction. However, the importer must pay for the watches on March 1,
though the expiration date of the futures contract is March 15. The importer can
hedge most of its exposure by buying March Swiss Euro contracts on February 1
with the intention lifting the hedge on March 1. Because Euro contracts are
available from the IMM in units of 125,000, the importer would purchase two
March contracts.
The above explanation can be understood well by the following table:
TABLE-2
Buying Two Euro Futures Contracts on February 1
Spot Market Futures Market
For March 15 Delivery
Exchange rate $0.6667/SF $0.6655/SF
Cost of SF 250,000 $166,675 $166,375
Action taken None Buy March 15
contract
The importer could trade out of the contracts by selling them before receiving a
delivery notice. The importer could buy 250,000Euros in the futures market for $
166,375 on March 15. The only risk that the company still faces comes from the
difference in the value of the contract on March 1 and its value on March 15.
Assume that by March 1 the following two things would happen:
1. The spot rate appreciates to $ 0.7658 and
2. The futures rate rises to $0.7650
In these situations let us see what the importer would do:
In the above situation the importer could close out the Euro futures contracts by
selling them on March 1. This situation can be well understood by the following
table:
TABLE-3
Reversing the Earlier Futures Contracts
Future Market
Spot Market for March 15 Delivery
Exchange rate $0.7658/SF $o.7650/SF
Cost of SF250,000 $191,450 $191,250
Action taken Buy SF250,000 Sell March 15 contract
On March 1, the importer purchases 250,000 Euros in the spot market for $
191,450 and settles its import bill. But, this $191,450 is higher than its original
value on February 1 in other words, the exchange loss from the spot transaction is $
24,775. The futures contract the company sold on March 1 ($191,250) is higher
($24,875) than the $166,375 the company anticipated in the futures contract it
purchased on February 1; in other words, the exchange gain form the futures
transactions is $24,875. The $24,875 gain form the futures transaction exceeds the
$24,775 loss from the spot transaction. The risk that the imported assumed on
February 1 by purchasing two contracts whose maturity did not coincide with the
March 1 usage date currency resulted in a wide fall exchange gain of $100
($25,875-$24,775). This $100 gain arose form the difference between the spot rate
and the futures rate prevailing on the day the contracts were liquidated. This
differences the basis.
The basis, unlike the spot rate itself, is relatively stable and narrows toward zero
as the contract moves toward maturity. For example, the basis on February 1 was
$0.0012 per franc ($0.6667-$0.6655), while by March 1 it had shrunk to $0.0008
($0.7658-$0.7650). The degree of uncertainty about the futures price diminishes
further as the contract approaches its March 15 expiration date. On March 15, the
futures rate, in effect, becomes the spot rate.
The difference of $0.0004 /SF in the basis between February 1 and March 1
accounted for the wind fall exchange gain of $100.This gain might easily have been
an exchange loss of a similar amount if the exchange rate of the Swiss franc had
depreciated during the same period. The important point is that the importer was
protected form any major loss regardless of exchange---- rate movements. For
example, if the importer had not purchased the futures contract and bought 250,000
francs in the spot market on March 1, the watches would have cost an additional
$24,775.
Frequent futures traders may try to coordinate trading between two different
markets or two different currencies through a strategy called spread trading. Spread
trading means buying one contract and simultaneously selling another contract.
They will always make money on one contract and lose money on the other
contract. Thus, they may make or lose more money on the one contract than they
lose or make on the other, but they are protected from major loss regardless of
exchange-rate movements.
Reference:
BhallaV.K, International Financial Management, Text and Cases. Fourth
Revised and Enlarged Edition, Anmol Publications Pvt.Ltd.New
Delhi.(Different Pages)
Alan. C.Shapiro, Multinational Financial Management. Prentice Hall.
REVIEW QUESTIONS:
1. What is meant by currency futures?
2. What is meant by currency forwards?
3. Compare and contrast between Future and Forward Markets.
4. Bring the special features of the Future Market.
5. Bring out the special features of the Forward Market.
6. Explain currency future quotes.
7. Explain the operation of the future and forward markets.
8. What is Clearing House and Clearing Margins?
CURRENCY OPTIONS.
LESSON - 2
Lesson Outline:
Introduction
Basic terms
Market Structure
Currency Options
Currency Option Pricing
Currency Call Options
Currency Options for Whom
By reading this lesson you would be able to understand:
What is meant by currency options.
Basic terms of currency options.
You will learn about market structure.
What are currency options and call options.
Who requires currency options.
Introduction:
The forward contract provides an exchange rate for the future but one faces
number of circumstances where it may be desirable to have flexibility than a
forward provides. For example, a software manufacturer in India may have sales
priced in U.S dollars as well as a France Frank in Europe. Revenue can be realized
in either France Frank of Dollars though this depends upon the relative strength of
the two currencies. In such a situation the use of forward of futures would be
inappropriate. The matter of hedging does not arise because it would be like
hedging something which the company does not have. Therefore, what is called for
is a foreign-exchange option right but not the obligation to exchange currency at a
predetermined rate.
The Definition or the Basic Terms:
A foreign-exchange option is a contract for future delivery of a specific
currency in exchange for another, in which the holder of the option has the right to
buy or sell the currency at an agreed price. The right to buy is a call ; the right to
sell , a put. For such a right the buyer pays a price called the option premium. The
option seller receives the premium and is obliged to made delivery at the agreed-
upon price if the buyer exercises his option. In some options, the instrument being
delivered is the currency itself, in others, it is a futures contract on the currency.
American options permit the bolder to exercise at any time before the expiration
date, European options only on the expiration date.
Structure of the Market
Options are purchased and traded either on an organized exchange (such as the
Philadelphia Stock Exchange on in the over-the counter (OTC) market. Exchange-
traded options or listed options are standardized contracts with predetermined
exercise prices, standard maturities (one, three, six, nine, and twelve months), and
fixed maturities (March, June, September and December). Options are traded in
standard contracts half the size of the IMM futures contracts, Cross-rate options are
also available for the DM/Y,
?/DM, and ?/Y. By taking the U.S. dollar out of the equation, cross-rate option
allow one to hedge directly the currency risk that arises when dealing with non
dollar currencies. The PHLX trades both American style and European style
currency options. It also trades month end options which ensures the availability of
a short-term currency options at all times and long term options which extend the
available expiration months on PHLX dollar based and cross rate contracts
providing for 18, 24, 30 and 36 months European style options. On a later date the
PHLX introduced a new option contract ? called Virtual Currency Option, which is
settled in us dollars rather than in the underlying currency.
Other organized options exchanges are located in Amesterdam (European
Options Exchange), Chicago (Chicago Mercantile Exchange) and Montreal
(Montreal Stock Exchange) OTC options are contracts whose specifications are
generally negotiated as to the amount, exercise price and rights, underlying
instrument, and expiration. OTC currency options are traded by commercial and
investment banks in virtually all finance centers. OTC activities is concentrated in
London and New York and it centers on the major currencies, most often involving
U.S. dollars against pounds sterling, Deutsche marks, Swiss francs, Japanese yen,
and Canadian dollars Branches of foreign banks in the major financial centers are
generally willing at write options against the currency of their home country.
The structure of the OTC options market consists of two sectors-
1. Retail Market:
This market is composed of nonblank customers who purchase from
banks what amounts to customized insurance against adverse exchange rate
movements and,
2. Whole Sale Market
A whole sale market is composed of commercial banks, and
specialized trading firms. This is mainly involve in inter bank OTC trading,
trading on the organized exchanges.
Most retain customers for OTC options are either corporations active in
international trade of financial institutions with multicurrency asset portfolios.
These customers could purchase foreign exchange puts of calls on organized
exchanges, but they generally turn to the banks for options in order to find precisely
the terms that match their needs. Contracts are generally tailored with regard to
amount, strike price, expiration date and currency.
Currency call Options:
After understanding the structure of the currency option market- both the
retail and the whole sale markets, it would be useful to understand the currency call
options. In the following paragraphs we would be involved in understanding the
currency options available to a buyer.
A currency call option is a contract that gives the buyer the right to buy a
foreign currency at a specified price during the prescribed period. Firms buy call
options because they anticipate that the spot rate of the underlying currency will
appreciate. Currency option trading can take place for hedging or speculation.
Hedging in the call Option Market:
Multinational companies with open positions in foreign currencies can
utilize currency call options. For example, suppose that an American firm orders
industrial equipment form a German company, and its payment is to be made in
German marks upon delivery. A German mark call option call option lacks in the
rate at which the U.S company can purchase marks for dollars. Such an exchange
between the two currencies at the specified strike price can take place before the
settlement date. Thus the call option specifies the maximum price which the U.S.
company must pay to obtain marks. If the spot rate falls below the strike price by
the delivery date, the importer can buy marks at the prevailing spot rate to pay for
its imports and can simply let its call option expires.
Speculating in the call Option Market:
Firms and individuals may speculate with currency call options based on
their expectations of exchange-rate fluctuations for a particular currency. The
purpose of speculation in the call option market is to make a profit from exchange-
rate movements by deliberately taking an uncovered position. If a speculator
expects that the future spot rate of a currency will increase, he makes the following
transactions:
The speculator will:
1. Buy call options of the currency
2. Wait for a few months until the spot rate of the currency appreciates high
enough
3. Exercise his option by buying the currency at the strike price, and
4. Sell the currency at the prevailing spot rate.
In order to understand it better let us have an example:
Assume that the call premium per English pound on March 1 is 1.10cents,
the expiration date is July, and the strike price is $1.60. Ms. Stuti anticipates that the
sot rate of the pound will increase to $ 1.70 by June 1. If Ms. Stuti`s expectation
proves correct, what would be her dollar profit from speculating one pound call
option in the call option market?
Ms. Stuti could make a profit of $2,781.25 by doing the following trading activities:
1. Buy call options on March 1
-$0.0110 per pound
2. Exercise the option on June 1
-$1.6000 per pound
3. Sell the pound on June 1
+$1.7000 per pound
------------------------------------
4. Net profit as of June 1
+$0.0890 per pound
5. Net profit per contract ?31,250x$0.0890=$2,781.25
Stuti does not need to exercise her call options in order to make a profit.
Currency call option premiums raise and fall as exchange rates of their underlying
currency rise and fall. If call options become profitable, their premiums will rise.
They can be sold on an exchange just like any foreign currency itself. Therefore, a
call option holder such as Stuti can save the expense and bother of taking
possession of the currency and selling it.
Currency Put Options:
A currency put option is simply a contract that gives the holder the right to
sell a foreign currency at a specified price during a prescribed period. People buy
currency put options because they anticipate that the spot rate of the underlying
currency will depreciate. Multinational companies who have open positions in
foreign currencies can employ currency put options to cover such positions. For
example, assume that an Indian company which has sold an airplane to a Japanese
firm and has agreed to receive its payment in Japanese yen. The exporter may be
concerned about the possibility that the yen will depreciate when it is scheduled to
receive its payment from the importer. To protect itself against such a yen
depreciation, the exporter could buy yen put options, which would enable it to sell
yen at the specified strike price. In fact, the exporter would lock in the minimum
exchange rate at which it could sell Japanese yen in exchange for U.S. dollars over
a specified period of time. On the other hand, if the yen appreciates over this time
period, the exporter could let the put options expire and sell the yen at the prevailing
spot rate.
Individuals may speculate with currency put options based on their
expectations of exchange rate fluctuations for a particular currency. For example, if
speculators believe that the German mark will depreciate in the future, they can buy
mark put options, which will entitle them to sell marks at the specified strike price.
If the mark`s spot rate depreciates as expected, they can buy marks at the spot rate
and exercise their put options by selling these marks at the strike price. Speculators
do not need to exercise their put options in order to make a profit. They could make
a profit from selling put options because put option premiums fall and rise as
exchange rates of the underlying currency rise and fall. The seller of put options has
the obligation to purchase the specified currency at the strike price from the owner
who exercises the put option. If speculators anticipate that the currency will
appreciate, they might sell their put options. But if the currency indeed appreciates
over the entire period, the put option will mot e exercised. On the other hand, if they
expect that the currency will depreciate, they will keep their put options. Then they
will sell their put options when the put option premiums go up.
Hedging Currency Positions (Various Options)
Hedging currency has various options such as ?with foreign currency
options, hedging with currency futures and contracts etc.
Let us now explain each one by one:
Hedging Currency Positions with Foreign Currency Options:
In 1972, the flexible exchange rate system was re established and since then
the multinational corporations, international banks and governments have had to
deal with the problem of exchange rate risk. Until the introduction of currency
options, exchange rate risk usually was hedged with foreign currency forward or
futures contracts. Hedging with these instruments allows foreign exchange
participants to lock in the local currency values of their revenues of expenses.
However, with exchange-traded currency options and dealer`s options, hedgers, for
the cost of the options, can obtain not only protection against adverse exchange rue
movements, but benefits if the exchange rates move in favorable directions.
This can be understood with the help of an example.
Suppose a U.S. computer corporation sells one of its mainframe computers
to a German manufacturing company for 625,000 DM, with the payment to be
made in Deutsche marks by the German company to the U.S. Company at the end
of three months. Suppose the current exchange rate is $.40/DM. Thus, if the U.S
Company were paid immediately and the marks were converted, it would receive
$250,000. Since payment is not due for three months, the US company faces both
the risk that the $/DM exchange rate could decrease, resulting in fewer dollars, and
the possibility of greater dollar returns if the $/DM exchange rate increases. For the
costs of DM put options, the US. Company can protect its dollar revenues from
possible exchange rate decreases while still benefiting if the exchange rate
increases.
Hedging with Currency Futures and Contracts:
With the following options the foreign currency can be hedged.
1. By going long in a currency call option, the investor can lock in the
maximum dollar costs of a future cash outflow or liability denominated in a
foreign currency while still maintaining the chance for lower dollar outlays
if the exchange rate decreases. In contrast, by going long in a currency put,
the investor can lock in the minimum dollar value of a future inflow or asset
denominated in foreign currency while still maintaining the possibility of a
greater dollar inflows in case the exchange rate increases. With foreign
currency futures and forward contracts, the domestic currency value of
future cash flows or the future dollar value of assets and liabilities
denominated in another currency can he locked in. Unlike Option hedging,
however, no exchange rate gains exist when futures or forward contracts are
used.
2. Hedging Future Currency Cash Flows With A Na?ve Hedge
Large multinational corporations usually hedge their currency
positions in the inter-bank forward market, whereas smaller companies,
some portfolio managers, and individuals often use the futures market.
Either way, the currency position usually is hedged with a na?ve hedging
model in which the number of futures or forward contracts is equal to the
value of the foreign currency position to be hedged.
To illustrate currency hedging, consider the option hedging example
presented above in which a U.S company expected a receipt of 625,000 DM
at the end of three months. Instead of hedging with a DM put, suppose the
company decides to hedge its receipt with a DM futures contracts expiring at
the end of three months, currently trading at Sf =$0.40/ DM when the spot
exchange rate is at S0 =$0.40/ DM. Since the contract size on the DM
futures contract is 125,000 DM, the company would need to go short in five
DM contracts, if it uses a na?ve hedging approach:
($0.40 / DM) (625,000 DM)
($0.40/ DM) (125,000 DM) =5
Doing this, the company would, in turn, ensure itself of a $250,000 receipt
at expiration when it converts its 625,000 DM to dollars at the spot $ / DM
exchange rate and closes its short futures position.
If a multinational has a future debt obligation that is required to pay in
foreign currency; then it could lock in the dollar cost of the obligation by
taking a long futures or forward position. This hedging strategy where the
dollar costs of purchasing 625,000 DM at the end of three months is hedged
with five long DM contracts priced at Sf=$0.40 / DM. In this case, the net
costs of purchasing the Maria on the spot and closing the futures is
$250,000, regardless of the spot exchange rate.
Currency Options for whom i.e. who needs Currency Options
Currency options are useful for all those who are the players or the users of
the foreign currency. This is particularly useful for those who want to gain if the
exchange rate improves but simultaneously want a protection it the exchange rate
deteriorate. The most the holder of an option can lose is the premium he paid for it.
Naturally, the option writer faces the mirror image of the holder`s picture: if you
sell an option, the most you can get is the premium if the option dies for lack of
exercise. The writer of a call option can face a substantial loss if the option is
exercised: he is forced to deliver a currency-futures contract at a below-market
price. If he wrote a put option and the put is exercised, then he is obliged to buy the
currency at an above-market price.
Foreign exchange options present an asymmetrical risk profile unlike
futures, forwards and currency options. This lopsidedness works in favor of the
holder and to the disadvantage of the writer. This is why because the holder pays for
it i.e he takes the risk. When two parties enter into a symmetrical contract ;ole a
forward, both can gain or lose equally and neither party feels obliged to charge the
other for the privilege. Forwards, futures, and swaps are mutual obligations; options
are one-sided. The holder of a call has a downside risk limited to the premium paid
up front; beyond that he gains one-for ?one as the price of the underlying security.
One who has brought p put option gains one-for-one as the price of the underlying
instrument falls below the strike price. Traders who have written or sold options
face the upside down mirror image profit profile of those who have bought the same
options.
From the asymmetrical risk profile of options, it follows that options are
ideally suited to offsetting exchange risks that are themselves asymmetrical. The
risk of a forward-rate agreement is symmetrical; hence, matching it worth a
currency option will not be a perfect hedge. Because doing so would leave you with
an open, or speculative, position. Forward contracts, futures or currency swaps are
suitable hedges for symmetrical risks. Currency options are suitable in which
currency risk is already lopsided, and for those who choose to speculate on the
direction and volatility of rates.
Options are not only for hedgers, but also for those who wish to take a
view. However, for one who is, say, bearish on the deutschemark, a DM put is not
necessarily the best choice. One can easily bet on the direction of a currency by
suing futures or forwards. A DM bear would simply sell DM futures, limiting his
loss, if wants to do so, via a stop loss order.
For an investor who has a view on direction and on volatility, the option is
the right choice. If you think the DM is likely to fall below the forward rate, and
you believe that the market has underestimated the mark`s volatility, then buying a
put on German marks is the right strategy.
Who needs American option? Because if offers an additional right- the
privilege of exercise on any date up to the expiration date- it gives the buyer greater
flexibility and the writer greater risk. American options will therefore tend to be
priced slightly higher than European options. Even so, the American option is
almost always worth more alive` than dead, meaning that it pays to sell rather
than exercise early. The reason for this statement lies in the fact that most option
trade at a price higher than the gain that would be made from exercising the option.
REVIEW QUESTIONS:
1. What is meant by currency options?
2. What are major differences between forward and futures contacts?
3. Explain the market structure for currency options.
4. Explain currency option pricing.
5. Explain with example the currency call options.
6. What do you mean by speculating in the Call Options Market?
7. Examine various aspects of the currency put options.
8. Explain hedging positions with foreign currency options.
9. Explain with example hedging future currency cash flows with a na?ve
hedge.
10. Explain who needs options?
SWAPS
LESSON-3
Lesson Outline
Introduction
The concept
Growth of the Swap Market
The Basic Swap Structure
After studying this lesson you would be able to understand:
The concept of the Swap Market
The structure of the Swap Market
Growth and functioning of the Swap
Market
Introduction:
Exchange rate instability and the collapse of the Bretton Woods System and
particularly the control over the movement of the capital internationally, paved the
way for the origin of the financial swaps market. To day swaps are at the centre of
the global financial revolution. The growth is such that sometimes it looks like
unbelievable but it is true. Though its growth will continue or not is doubtful.
Already the shaking has started. In the plain vanilla dollar sector , the profits for
brokers and market makers, after costs and allocation of risk capital, are measured
in fewer than five basis points. This is before the regulators catch up and force
disclosure and capital haircuts. At these spreads, the more highly paid must move
on to currency swaps, tax-driven deals, tailored structures and schlock swaps.
The fact which is certain is that, although the excitement may diminish,
swaps will stay. Already, swaps have had a major macro economic impact forging
the linkage between the euro and the domestic markets, flattening the cash yield
curves, and reducing central bank monopoly influence on markets. We are all
swappers now. And remember the saying beware of honey offered on a sharp
knife when you are offered sweet deals. The problem in following the chaotic
process of this very important market is quite simply that he who knows does not
speak, he who speaks does not know. A glimpse of the growth of swap market and
a short list of the non proprietary tools in the swapper`s arsenal is given below:
The concept of the SWAPS:
The aim of swap contract is to bind the two counterparties to exchange two
different payment stream over time, the payment being tied, or at least in part, to
subsequent--and uncertain--market price developments. In most swaps so far, the
prices concerned have been exchange rates or interest rates, but they increasingly
reach out to equity indices and physical commodities. All such prices have risk
characteristics in common, in quality if not degree. And for all, the allure of swaps
may be expected cost saving., yield enhancement, or hedging or speculative
opportunity.
Portfolio management requires financial swaps which are simple in principle,
versatile in practice yet revolutionary. A swap coupled with an existing asset or
liability can radically modify effective risk and return. Individually and together
with futures, options and other financial derivatives, they allow yield curve and
currency risks, and liquidity and geographic market considerations, all to be
managed separately and also independently of underlying cash market stocks.
Growth of the SWAP Market:
In the international finance market most of the new products are executed in
a physical market but swap transactions are not. Participants in the swap market are
many and varied in their location character and motivates in exciting swaps.
However, in general the activity of the participants in the swap market have taken
on the character of a classical financial market connected to , and integrating the
underlying money, capital and foreign exchange market.
Swap in their current form started in 1981 with the well-publicised currency
swaps, and in the following year with dollar interest rate swaps. The initial deals
were characterized by the three critical features.
1. Barter- two counterparties with exactly offsetting exposures were
introduced by a third party. If the credit risk were unequal, the third party- if
a bank ? might interpose itself or arrange for a bank to do so for a small fee.
2. Arbitrage driven- the swap was driven by a arbitrage which gave some
profit to all three parties. Generally, this was a credit arbitrage or market-
access arbitrage.
3. Liability driven- almost all swaps were driven by the need to manage a
debt issue on both sides.
The major dramatic change has been the emergence of the large banks as
aggressive market makers in dollar interest rate swaps. Major US banks are in the
business of taking credit risk and interest rate risk. They, therefore, do not need
counterparties to do dollar swaps. The net result is that spreads have collapsed and
volume has exploded. This means that institutional investors get a better return on
their investments and international borrowers pay lower financing costs. This, in
turn, result in more competitively priced goods for consumers and in enhanced
returns pensioners. Swap therefore, have an effect on almost all of us yet they
remain an arcane derivative risk management tool, sometimes suspected of
providing the international banking system with tools required to bring about
destruction.
Although the swap market is now firmly established , there remains a wide
divergence among current and potential users as to how exactly a given swap
structure works, what risks are entailed when entering into swap transactions and
precisely what the swap market is and, for that matter is not.
The basic SWAP Structures
The growth and continued success of the swap market has been due small
part to the creativity of its participants. As a result, the swaps structures currently
available and the future potential structures which will in time become just another
market norm are limited only by the imagination and ingenuity of those
participating in the market. Nonetheless, underlying the swap transactions seen in
the market today are four basic structures which may now be considered as
fundamental. These structures are:
- the Interest Rate Swap
- the Fixed Rate Currency Swap
- the Currency Coupon Swap
- the Basis Rate Swap
The Currency SWAP Market: Main Features
The oldest and the most creative sector:
The currency swap market is the oldest and most creative sector of the swap
market. This is not distinguished in market terms between the fixed rate currency
swap and the currency coupon swap. There is no distinction in market terms
between these two types of currency swaps because the only difference is whether
the counter currency receipt/payment is on a fixed or floating basis- in structure and
result, the two types of swaps are identical and it is a matter of taste (or preference)
for one or both counterparties to choose a fixed or floating payment. When the
dollar is involved on one side of a given transaction, the possibility to convert a
fixed rate preference on one side to a floating rate preference on the other side
through interest rate swap market makes any distinction even more irrelevant.
However, for those who like fine distinctions, there is a tendency in the market to
regard the fixed rate currency swap market as more akin to the long date forward
foreign exchange market (because when one is executing a fixed currency swap one
may often be competing with the long-date FX market) and the currency coupon
swap market as more akin to the dollar bond/ swap market (because the dollar bond
issuer compares the below LIBOR spread available in the dollar market to that
available, say, through tapping the Swiss Franc market.)
Most Interesting Sector of the Swap Market:
Whatever distinctions one wishes to draw or not to draw between the two
basic types of swaps in the currency swap market, there are many reasons why this
market is the most creative and therefore, most interesting sector of the swap
market. While still smaller than the dollar interest swap market, the currency swap
market has great and perhaps even greater potential for growth than the dollar
market, particularly in the light of the growth in local/ Euro capital markets in a
wide range of currencies.
The Primary and the Secondary Sector:
One can classify activity in the currency swap market into the same two
basic sectors as the interest swap market ? a primary and secondary sector. In the
currency swap market, the primary sector is dominant across the yield curve and the
key motivating forces underlying this market are new money and hedging in
that order. New money or the willingness to execute swap-related public or
private financing in one currency to achieve a finer cost or enhanced availability in
another currency is the key motivating force behind the currency swap market,
particularly for banks and sovereign entities. Such entities have had large capital
and refinancing requirements in recent years. The capacity of any one market (eg:
the Eurodollar bond market) to provide all of these requirements at the finest
possible cost has been limited. Hence, many banks and sovereign have been willing
to approach the private and public debt markets in currencies for which they have
no natural requirements (but which the swap market can use) in order to reduce
costs and / or gain greater access to a particular currency which is required.
Restructuring, or hedging current debt portfolios, cash flows or investments, is
clearly an influence of second order is comparisons to the influence of new
money. The flexibility of loan repayment clauses and the fact that many corporate
and sovereign entities have found their access to a wide range of securities markets
greatly expanded in recent years means that even if the fundamental motivation of a
currency swap is restructuring/ hedging, this would normally be preceded by an
issuer first obtaining a cheaper cost of funds in the base currency through securities
or near security transactions.
The Creativity:
From the market point of view, the driving force of the currency swap
market is creativity. Structures in the currency swap market range from the
extremely simple to the complex, multi-faceted, multi-counterpart transactions
whose economies exist in the dimensions available only to the mathematician. One
is limited in the currency swap market only by the problem to be solved, one`s
imagination, the skills of your personal computer operators and of course, the
ability of your colleagues to find suitable counterparts around the world at the right
time
and
price.
As opposed to the dollar market, where capital commitment has become
increasingly important, the key in the currency capital commitment has become
increasingly important, the key in the currency swap market is still commitment to
creative problem-solving and development of a swap distribution system on a
global basis--classic investment banking.
Individual Demand and Supply Interplay:
Warehousing in the primary market is not widespread due to the difficulty
of covering the interest rate risks while the swap is in position. A swap arranger can
cover the foreign exchange risks associated with booking open a position in a
given currency but often times the arranger cannot cover against a movement in
interest rates for that currency or is forced to use (generally poor) surrogate cover.
This is due to the fact that currency swap rates generally move to the laws of their
own supply and demand and do not necessarily relate to say, local government bond
markets where cover in some currencies can be obtained (particularly sterling and
Deutschmarks). But taking of position does not take place among a few selected
players and such market-making is not done on a much wider spread basis versus
capital market rates than in the dollar interest swap market. However, until better
and more consistent relationship between swap rates and the available interest cover
develops, position-taking in the currency swap market will remain very much akin
to long-date forward foreign exchange dealing and less toward the classic arbitrage
model of the swap market.
The Most Important Currencies of the Swap Market:
The most important currencies in the swap market in rough order of
magnitude are the Swiss Franc, Yen, Deutschemarks, Pound sterling and Canadian
dollar. These currencies are popular in the swap market due to their low interest
rates (versus Dollar) and the relative ease of access by a wide range of issuers to
private and public debt in the Euro and domestic markets of these currencies.
Many supranational and sovereign borrowers find their access to the debt markets
of such currencies constrained (versus their sometimes quite large requirements)
and therefore make extremely active and frequent use of the currency swap market.
Such entities either lend in their currencies (and are therefore covering/ matching
assets with liabilities) or are trying to diversify their debt portfolios away from the
dollar and the costs of the vagaries of that currency can impose on national budgets.
Dollar's Domination:
Even after so much development in the swap market, the domination of
dollar continues. Though this is also the fact that many direct currency combination
continues such as Yen/Swiss Franc. The other high interest rate currencies involved
in the currency swap market are viewed as speculative vehicles for aggressive debt
portfolio managers or companies in the local market which would have to pay
dearly for fixed rate debt. This late comer accounts for the active use of exotic
currency debt markets by prestigious international issuers. This has occurred
recently in a number of capital markets in which the first few Euro issues are
completed at wide divergence to the domestic market rates. Thus, the swaps which
become available in this way, have accounted for the presence of many high ?
powered issues. The quality image gained by such issues, should on these markets
has gained acceptance for new market and hence, fostered their growth.
In sum, the primary sector of the currency swap market is dominated by
new money considerations by issuers and on the other side, by greater access to a
select few low interest-rate debt markets by often the same type of entities. There is,
however, a greater diversity by type of participants in the currency swap market
than the interest swap market with financial institutions, particularly banks, playing
a smaller role in the currency market and sovereigns, supranational and corporate
playing a relatively larger role than such entities do in the dollar swap market.
Position-taking (capital commitment) is still less important than commitment to
creativity and distribution capacity among arrangers. While the currency swap
market is highly competitive, there is still the possibility to beat your competitor by
being smarter, quicker and developing niches of special expertise in a particular
currency.
Highly Opportunistic Sub-sector:
The secondary market is a highly opportunistic sub-sector of the currency
swap market and, judging by Bankers Trust`s own activities in this market, the
secondary market in currency swaps is relatively larger in comparison to the
primary market. Some of the experts are of the view that this is due to a given swap
counterparty having two chances to win on interest and exchange rates- in a
currency swap and that with the enormous volatility of the dollar, a chance to win
big on an exchange rate play. Although the original motivation may be to create a
currency swap but the primary motive in the secondary market is to take profit
before a currency move places the swap into an unprofitable position.
New Breed of Financial Management:
The secondary market phenomenon is an inherent part of the new breed of
financial management which aggressively manages their cash flows and debt
portfolios because they are judged by profits. The spreads tend to be relatively
wider in the secondary currency than the secondary interest swap markets, move
quickly when an exchange rate breaks is the key to the level of profitability. The
exchange rate effects the profitability of a swap reversal is so much that the case of
exchange rate that excellent prices and highly attractive rates can be obtained in the
secondary market. The reverser needs to move quickly to capitalize on his exchange
rate gain. This may lead to the virtual wholesale shutdowns of the primary market
in currency swaps. This is so because of the fact that many counterparties want to
reverse at the same time. Consequently this will lead to substantial discounts in
interest rates on the secondary market versus the primary market.
Position-taking and Market-making:
Unlike in primary market, the position-taking and market-making are very
common in the secondary market due to the excellent pricing available in the
secondary market, most of the times. Like the dollar market, sophisticated financial
managers are aware that the credit risks are greater in currency swaps. When the
time comes to reverse a position these sophisticated financial managers will make a
market on the original transactions.
The fixed rate currency Swap:
A fixed rate currency swap consists of the exchange between two
counterparties of fixed rate interest in one currency in return for fixed rate interest
in another currency.
Following are the main steps to all currency swaps:
1. Initial Exchange for the Principal:
The counterparties exchange the principal amounts on the
commencement of the swap at an agreed rate of exchange. Although this
rate is usually based on the spot exchange rate, a forward rate set in advance
of the swap commencement date can also be used. This initial exchange may
be on a notional basis of alternatively a physical exchange. The sole
importance of the initial exchange on being either on physical or notional
basis, is to establish the quantum of the respective principal amounts for the
purpose of ?(i) calculating he ongoing payments of interest and (ii) the re-
exchange of principal amounts under the swap.
2. Ongoing Exchanges of Interest:
Once the principal amounts are established, the counterparties
exchange interest payments based on the outstanding principal amounts at
the respective fixed interest rates agreed at the outset of the transaction.
3. Re-exchange of the Principal Amounts:
On the maturity date the counterparties re-exchange the principal
amounts established at the outset. This straight forward, three-step
process is standard practice in the swap market and results in the effective
transformation of a debt raised in one currency into a fully-hedged fixed-rate
liability in another currency.
In principle, the fixed currency swap structure is similar to the conventional
long ?date forward foreign exchange contract. However, the counterparty nature of
the swap market results in a far greater flexibility in respect of both maturity periods
and size of the transactions which may be arranged. A currency swap structure also
allows for interest rate differentials between the two currencies via periodic
payments rather than the lump sum reflected by forward points used in the foreign
exchange market. This enables the swap structure to be customized to fit the
counterparties exact requirements at attractive rates. For example, the cash flows of
an underlying bond issue may be matched exactly and invariably.
The Currency Coupon SWAP:
The currency coupon swap is combination of the interest rate swap and the
fixed-rate currency swap. The transaction follows the three basic steps described for
the fixed ?rate currency swap with the exception that fixed-rate interest in one
currency is exchanged for floating rate interest in another currency. By using the
currency coupon swap the benefit which can be obtained, can be explained with the
following example. Suppose an Indian corporate wished to enter a major leasing
contract for a capital project to be sited in Japan. The corporate wanted to obtain the
advantage of funding through a Japan`s lease which provided lower lease rentals
due to the Japan tax advantages available to the Japan lessor. However, the
Corporate was concerned by both the currency and interest rate exposure which
would result from the yen based leasing contract. The structure provided by
Hankers Trust enabled the Corporate to obtain the cost benefits available from the
Japan lease and at the same time convert the underlying lease finance into a fully ?
hedged fixed-rate yen liability. Under the structure Bankers Trust paid, on a
quarterly basis, the exact payments due on the Corporate`s yen based Japan lease in
return for the Corporate paying an annual amount of fixed Japanese Yen to
Banker`s Trust. The amount for fixed Japanese Yen payable reflected the beneficial
level of the Japanese Yen lease payments.
The Basis Rates
A fast developing area in the international swap markets is the basis rate
swap. The structure of the basis rate swap is the same as the straight interest rate
swap, with the exception that floating interest calculated on one basis is exchanged
for floating interest calculated on a different basis. The forerunner of this type of
swap was the US Dollar Prime Rate LIBOR swap. However, an even larger market
has developed for the exchange of I month US Dollar LIBOR for 6 month US
Dollar LIBOR and more recently US Dollar LIBOR for US Dollar commercial
paper at much finer rates than those available on the foreign exchange market.
The availability of the basis rate swap market provides an excellent method
for entities to arbitrage spreads between different floating rate funding sources.
More importantly, it provides a discreet and most efficient method for European
entities in particular to stimulate the US Commercial Paper funding market without
the necessity of meeting the stringent US requirements for a Commercial Paper
programme. To illustrate, consider a transaction structured by Bankers Trust which
enabled an European bank to obtain effective 30 day commercial paper funding by
converting its 6 month US Dollar funding base into 30 day commercial paper via a
basis rate swap. The counterparty to the transaction was a second European bank
wishing to match its commercial paper funding programme to its LIBOR asset base.
SWAP Risk and Exposure
The great bulk of swap activity of date has concentrated on currencies and
interest rates, yet these do not exhaust the swap concept`s applicability. As one
moves out the yield curve, the primary interest rate swap market becomes
dominated by securities transactions and in particular the Eurodollar bond market.
The advent of the swap market has meant that the Eurodollar bond market now
never closes due to interest rate levels: issuers who would not come to market
because of high interest rates now do so to the extent that a swap is available.
Indeed, the Eurodollar bond market owes much of its spectacular growth to the
parallel growth of its swap market. The firms that now dominate lead management
roles in the Eurodollar bond market all have substantial swap capabilities and this
trend will continue. One extension is seen in the beginning of the market for equity
swaps- an exchange of coupons on some bonds for dividends on some equities, or
an index instrument thereof (capital appreciation also may be included on one or
both sides of the swap). The purpose is to earn equity returns when the investor
deems them promising but without the transactions costs of liquidating an existing
bond position or building an outright equities position, while also providing the
complication of unfamiliar local market and the time and trouble of stock-picking if
the index will suffice. Equity swaps (and, indeed, all swaps) further may be
enhanced by options features customized to the interests of the credit worthy,
sophisticated investor
Commodities are another fertile area for swaps in view of the limited scope
of price protection alternatives. There is modestly growing swap activity in the
principal non-ferrous metals, such as copper and aluminium, and rather more in
gold, based partly on the advantages of the advantages of the swap investment for
protecting long ?term project financing vulnerable to price instability. The major
focus, however, now lies on petroleum and petroleum products. This is the physical
commodity sector most critical to fine economic uses. Since the mid-1980s, this
sector has become one of the most heavily traded in the cash and futures market
worldwide.
Essentials for reducing Swap risks:
There are certain precautions which are suggested to be taken to reduce the
swap risk. They are as follows:
1. Undertaking more stringent credit analyses and use greater care in
selecting counterparties:
This provides the best insurance against the swap risk. Having a
financially strong counterparty not only minimizes the chances of default
hut also facilitates the transfer of a swap, for either profit or lack of need, or
both.
2. Master agreements:
These stipulate the all swaps between two parties are cross-defaulted to
each other, default on any one swap triggers suspension payments on all
others covered in the agreement. Such arrangements normally pre-suppose
frequent transactions between the parties. They also are most effective in
reducing exposure when a balance exists in swap positions between paying
and receiving fixed rate flows, and between notional principal amounts and
maturities.
3. Collateralisation:
Collateralization with marketable securities has become an essential
feature of swaps with dubious credits. The right to call can be mutual which
normally applies only in one direction, depending on the relative strength of
the two parties.
4. Better documentation:
More protective documentation in swap agreements can provide
trigger points for remedial action in advance of actual default. Users could
require, for example, that the various tests of financial condition found in
credit agreements can provide trigger points for remedial action in advance
of actual default. Users could require, for example, that the various tests of
financial condition found in credit agreement are incorporated into swaps
contracts.
5. Net settlements:
To minimize risk, a swap user is will advised to insist on settlement
of all payments on the same day and on a net basis. A payments lag can
leave a user vulnerable to loss of its counterparty defaults before the
corresponding payment has been made.
Review Questions:
1. In a currency swap, counterparties exchange the same sums at the
beginning and the end of the swap period. Explain how this practice relates
to the custom of making interest payments during the life of the swap
agreement.
2. Why is an interest rate swap simpler to a futures contract?
3. How con an interest rate collar be created?
4. In a currency swap, both the final principal and the periodic coupons are
exchanged. Why is this unnecessary in an interest rate swap?
5. What is a swaption?
6. Explain how you would value a swap that is the exchange of a floating
rate in one currency for a fixed rate in another currency.
7. Explain the difference between the credit risk and the market risk in a
financial contact / Which of the risks can be hedged?
8. Explain the synthetic futures and distinguish between the future contracts
and option contracts.
THE INTEREST RATE SWAP
LESSON-4
Lesson Outline
Introduction
Primary market
Secondary market
Reasons for slower growth
After reading this lesson you would be able to understand:
What is interest SWAP
The meaning and working of the primary
market
The meaning and working of the secondary
market
Reason for the slow growth of the market
Introduction:
The basic structure of an interest rate swap consists of the exchange between
two counterparties of fixed rate interest for floating rate interest in the same
currency calculated by reference to a mutually agreed notional principal amount.
This principal amount, which would normally equate to the underlying assets or
liabilities being swapped by the counterparties, is applicable solely for the
calculation of the interest to be exchanged under the swap. At no time it is
physically passed between the counterparties. The counterparties are able to convert
an underlying fixed rate asset/ liability and vice-versa, through this straight forward
swap structure. The majority of the interest rate swap transactions are driven by the
cost savings to be obtained by each of the counterparties. These cost savings are
substantial and result from differentials in the credit standing of the counterparties
and other structural considerations.
Generally investors in fixed rate instruments are more sensitive to credit
quality than floating rate bank lenders. Accordingly a greater premium is demanded
of issuers of lesser credit quality in the fixed rate debt markets than in the floating
rate bank lending market. The counterparties to an interest rate swap may therefore
obtain an arbitrage advantage by accessing the market in which they have the
greatest relative cost advantage and then entering into an interest rate swap to
convert the cost of the funds so raised from a fixed rate to a floating rate basis or
vice-versa.
This ability to transfer a fixed rate cost advantage to floating rate liabilities
has led to many high quality credits issuing fixed rate Eurobonds purely to swap
and obtain , in many cases, sub-LIBOR funding. The use of this structure in a fixed
fate Eurobond issue enables the issuer to obtain substantial funding at points below
LIBOR. This most attractive of rates is made possible by (i) the careful timing of
the Eurobond issue to ensure its success at the finest of rates and (ii) the use of
exact hedging and a deferred swap accrual date to ensure the best possible swap
terms for the issuer. The counterparty to the swap may be a combination of banks
and corporate clients. The banks may want to hedge their fixed rate income into a
floating rate return that fully matched their floating rate liabilities in order to
alleviate interest rate exposure. The corporate clients may want to hedge their
floating rate binding into fixed rate liabilities for a size and maturity unavailable in
the direct fixed rate debt market. Acting as principal, the intermediary may be able
to provide both the banks and its corporate clients with swap terms to meet their
exact requirements and then subsequently lock the Eurobond issuer into an opposite
swap when the Eurobond market was most receptive to the issue. Interest rate swaps
also provide an excellent mechanism for entities to effectively access markets
which are otherwise closed to them. The ability to obtain the benefits of markets
without the need to comply with the prospectus disclosures, credit ratings and other
formal requirements and other formal requirements provides an additional benefit
especially for private companies. An excellent example of the swap market`s
flexibility in providing benefits is the growth of interest rate swaps using
commercial paper as the underlying floating rate basis. The interest rate swap
market also provides finance money with the perfect mechanism for managing
interest rate costs and exposure whilst leaving the underlying source of funds
unaffected. For example, the cost of fixed rate funding may be reduced in a
declining interest rate environment through the use of the interest rate swap
technique whilst leaving the underlying funding in place.
After a close observation of the interest rate swap market it is experienced
that it possess certain characteristics of a fairly well-organized financial market.
There are a larger number of players with fairly distinct roles in the market, there
arte several different structures of the market in which certain players specialize.
There is both a primary and a secondary market in interest swaps. Not only this,
there is sufficient liquidity in both the primary and secondary markets of certain
sectors such that a few players do trade or make markets in interest swaps and in
even fewer cases have significant capital commitments to the swap market.
After the above explanation, we are in a position to say that swap market
activities can be classified into two sectors--
1.The primary market and,
2. The secondary market.
The Primary market has the further divisions like ?source of raw material
for a interest rate swap-bank, financial market funding, hedging instruments and the
securities markets. European bond market can be taken as an example. The primary
sector can be distinguished by the activities like maturity and type of player. The
short term sector of the primary market is essentially an inter bank market
dominated by the funding and hedging activities of both large and small banks. The
banks are both providers and takers in the segment of the market depending on the
structure of their asset base. Since it is extremely volatile in price in terms of
spread, the market-making or position taking is, therefore only for the most
experienced dealers. For such dealers profit potential is high and risks in position ?
taking while similarly high, are manageable due to impressive array of instruments
available to manage risks. New York is the centre of this market with London and
Tokyo following it. The main participants are the banks which include a number of
brokers who have extended their normal money market dealing activities with
banks to include interest swap activities. Success in this segment of the primary
market does not depend only on close integration of an institution`s treasury and
swap operations, but also on distribution and in particular, the ability to move
positions quickly due to the price volatility and risks inherent to the market.
Inventory also quickly becomes stale in the short-term market because most
transactions are done on a spot` basis holding a position for a period of time may
therefore mean one`s inventory may not move irrespective of price. However, the
growth of the secondary market in the short term swaps has decreased the risks of
position ? taking in the short term secondary market. The use of financial futures
has been the special feature of the secondary market which create the other side` of
an interest swap. While financial futures-based swaps are highly complex to execute
properly, the very quick and sharp movements in this market and hence, the need to
wind and un-wind these structures to maximize profits has increased the liquidity
in the secondary market.
Excepting the yield, the primary interest rate swap market is dominated by
securities transactions and particularly the Eurodollar bond market. This market
segment is very large. It is estimated that some 75% of all Eurodollar bond issue are
swapped and the dollar fixed ?rate Eurobond market is currently running at an
annual rate of $50 billions plus. The Eurodollar bond market never closes due to
interest rate levels. Issuers who would not come to market because of high interest
rates now do so to the extent that a swap is available. The firms that now dominate
lead management roles in the Eurodollar bond market all have substantial swap
capabilities and this trend will continue. Pricing in this segment of the market is
exclusively related to the U.S. Treasury rates for comparable maturities and is
marked by the relative stability of these spreads by comparison to the short-term
market. The size of the Eurobond issues and the oversupply of entities able and
willing to approach the Eurobond market to swap into floating rate funds, most
major houses in the swap market now enter into swap agreements with an issuer
without counterparty, on the other side.
The ware housing activity is normally hedged in the U.S. Treasury of
financial futures market, leaving the warehouse manager with a spread risk, or the
difference between the spread at which he booked the swap with the issuer and
where he manages to find a matched counterparty. The relative stability of spreads
and a positively sloped yield curve have allowed the market to function reasonably
well on this basis with only occasional periods of severe oversupply in any
particular maturity. The major houses tend to spread their inventory across the yield
curve to reduce risk and to ensure ready availability of a given maturity for
particular clients` requirements.
Bids for bond-related swaps tend to differ between the major houses by only
a few basis points: the swap market is quite efficient in price given the few houses
who deal in bond market size and maturities. Hence, a premium is placed on
creating bond structures which offer the fixed-rate issuer a lower cost and therefore,
a better spread LIBOR. Apart from creative bond/ swap structures, the key to
successfully operating in this segment of the market for the bond/ swap arranger has
been the development of a highly refined sense of timing for the underlying issue.
While finding a window in the Eurodollar bond market has always been the sine
qua non for a successful lead manager, with the advent and development of the
swap market, the focus of the potential lead manager has shifted from an investor
window to a spread window. Given that the long term swap market operates on a
relatively stable spread level versus US Treasuries and the Eurodollar bond market
is notoriously volatile versus Treasuries for different types of issuers, a similar
premium to that of creativity applies to the lead manager who can locate a spread
window for a particular type of issuer. This creativity and search for a spread
window has sometimes led to mis-priced and/ or virtually incomprehensible bond
structures but more often than not, bond/ swap structures so created have provided
value to both the Eurobond investor and issuer.
However, it is clear that (below) LIBOR spreads available to issuers have
declined as the market has become more efficient in pricing the relative value of a
given swap: at the outset of the market, a AAA issuer could reasonably expect to
achieve 75-100 basis points below LIBOR on a bond/ swap; under current market
conditions. This same issuer might expect only 25-30 basis points below on a plain
vanilla bond/ swap. Indeed many issuers, particularly commercial banks, now find
it more cost-effective to approach the floating rate note market than the bond/ swap
market. The lower spreads available have gone almost entirely to the benefit of the
fixed-rate payer; intermediaries have seen their profit margins reduced to a very
substantial degree in the primary market. This reduced profitability and lower
spreads available has led, in turn, for most bond /swap arrangers to attempt to put
potential counterparties in direct contact with each other and eliminate the
intermediation of a commercial bank. This is most often a very difficult process due
to timing and credit considerations but there is a strong incentive now among all
parties concerned to see whether a direct write is possible on a new issue.
The long term secondary market for interest swaps is a highly opportunistic
segment of the market. As interest rate fluctuates, a fixed rate provider or taker may
find that a substantial profit can be realized by reversing the original swap or
canceling the original swap in return for an up-front cash payment. Several reasons
can be cited for the slower rate of growth of the interest swap market. The few of
them are explained below.
1. Banks executing fixed rate bond issues have represented a large portion
of the provider side of the swap market. Most of the banks executed a
bond/swap to gain long term floating rate funding for their long term
floating rate funding for their long term floating rate loans and therefore,
have no reason to reverse.
2. The odd dates thrown off by swap reversals are often difficult to close in
the market and thus what appears to be an interesting price on a spot
basis may become substantially less interesting when the odd dates are
taken into account.
3. Many swap intermediaries do not make markets to their clients with
whom the original swaps were written. In this case, now, the only option
available is to execute a mirror swap for which up-fronts cash will be
difficult to obtain and entails a doubling of credit risks for the reverser.
The market risk may be associated with the fixed flows, there is also risk associated
with the LIBOR side. An additional potential risk can be assumed depending on the
structure of the swap. When counterparty receives fixed payments semi-annually
and pays LIBOR semi-annually, potential risk is minimized.
Despite the problems explained above, the long term secondary market has
shown good growth and several houses have sponsored the growth of this segment
through commitment of capital, personnel and systems capabilities to market to
making in long term swaps.
Review Questions:
1. What do you understand by interest rate swap?
2. What is primary market?
3. Explain the main features of the secondary market.
4. Examine the objective of the interest swap market.
5. What are the reasons for the slow growth of the swap market?
6. Explain with an example the working of the interest swap market.
This post was last modified on 14 March 2022