1. General Bank Management (CAIIB)
International Banking (Module A) – PART-I
Foreign Exchange
Tanushree Mazumdar, IIBF

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

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

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

5. Definition of foreign exchange
Deposits, credits and balances payable in foreign currency
Drafts, travellers’ cheques, letter of credit or bill of exchange expressed or drawn in Indian currency but payable in foreign currency
Drafts, travellers’ cheques, L/Cs, etc. drawn by banks, institutions or persons outside India but payable in Indian currency
The above definition is as per FEMA (1999)

6. Exchange rate (1)
Denotes the price or the ratio or the value at which one currency is exchanged for another
Exchange rate is very dynamic
The foreign exchange market is round-the-clock market due to different time zones
Major participants- central banks, commercial banks, forex brokers, corporations, individuals

7. Factors affecting exchange rate
Major banks that act as market-makers always give two-way quotes; gives depth and volume to the market
Fundamental reasons
Technical reasons
Speculation

8. Fundamental reasons Balance of payments->surplus->appreciation
Growth rate of the economy-> higher growth->depreciation of currency
Fiscal policy-> financing of fiscal deficit influences exchange rate
Monetary policy->loose monetary policy-> depreciation of exchange rate

9. Technical reasons
Freedom or restrictions on capital movements can affect exchange rates to a large extent
Among other factors there are:
Huge trade surpluses of oil exporting countries
Capital moving from low-yielding currencies to high yielding currencies (interest differential)

10. Speculation Self-fulfilling prophecies
Anticipation of depreciation of a currency can cause dealers to sell that currency
Speculation serves to provide depth and liquidity to the forex market
Acts as a cushion as well- contrarian traders exist in the market

11. Types of exchange rate (1)
Ready/cash- Settlement of funds on the same day (date of the deal).
Tom- Settlement of funds takes place on the next working day of the date of the deal
Spot- Settlement of funds takes place on the second working day following the date of the deal

12. Types of exchange rate (2)
Forward- Delivery takes place on any day after the date of the deal
In the forex market all rates that are quoted are generally spot rates
When delivery takes place beyond the spot date then it is a forward transaction and the forward rate is applicable
Forward rate = Spot rate + Premium (- discount)

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

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

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

16. Example of a Chain Rule (1)
Query: If we have to remit French Francs to France from India how do we go about it? (We have to arrive at cross rates between FRF and INR.)
Mumbai interbank market:
US $ 1 = Rs /2650
London Market
US $ 1 = FRF /6.0550

17. Chain rule (2) At what rate can one buy FRF against rupees?
How many Rs----- = FRF 1?
FRF = US $ 1
US $ 1 = , therefore,
FRF = US $ 1 = Rs
Hence, FRF 1 = /6.0500
Or FRF 1 = Rs

18. Forward Rate (1)
Value date: It is customary, in foreign exchange market, to quote a rate to do the deal but exchange the currencies not on the same day but generally afterwards.
Forward rate: Has two components
Spot rate
Forward points or forward differentials
Forward rate is the rate when the value of the deal is fixed beyond the spot date i.e. beyond the second working day after the deal

19. Forward Rate (2)
Forward transactions are necessary in the foreign exchange market as they serve number of purposes like:
One can hedge or cover an existing future financial, commercial or trade related exchange risk
These types of deals, in combination with spot deals, are used for money market operations through ‘swap’ transactions
Taking a view of the market, these can be used for speculation

20. Forward rate (3)
When a currency is costlier in the future (forward) as compared to the spot, the currency is said to be at a premium vis-à-vis another currency
In ‘direct rate’ premium is added to both the buying and selling rate whereas discount is deducted
In ‘indirect rate’ premium is deducted and discount is added to the buying and selling rates

21. Forward rate (4)
Base currency is the currency which is being bought and sold and the other currency is incidental.
Forwards are quoted as follows
Spot/1 month 17/18
Spot/ 2 months 35/37
Spot/ 3 months 53/56
If forward differentials are in the ascending order (1st figure is lower than the 2nd) the base currency is at premium

22. Foreign exchange transactions (1)
Arbitrage: Is an operation by which one can make risk free profit by undertaking offsetting transactions.
Can be in interest rates: borrow in one centre and lend in another
Can be in exchange rates: Buy a currency in one market and sell in another
Arbitrage keeps exchange rates uniform in all markets

23. Foreign Exchange Transactions (2)
Merchant rates: Quotes offered to merchants (importers, exporters) by banks.
Inter-bank rates: The rates quoted by banks for dealing in the inter-bank market.
Merchant quotations: In India all merchant quotations for foreign currencies shall be in so many rupees for one unit of foreign currency except for Japanese Yen, Italian Lira and Belgian Franc (Rs/100 units of the currency)
All quotes are in four decimal places with the last two digits in the multiple of 25

24. Modes of remittances (1)
Telegraphic Transfers (TT) of funds are done from one centre to another by way of instructions through telex, telegram or SWIFT (Society for Worldwide Interbank Financial Transfer). Of late SWIFT is becoming popular
Mail Transfer (MT) of funds is done by way of instructions sent by mail. An MT is an order in writing on the correspondent bank/branch abroad to pay the beneficiary the sum mentioned

25. Modes of Remittances (2)
Demand draft (DD): A DD is an order in writing on the correspondent bank/branch abroad to pay the beneficiary the sum mentioned therein.
Fedai prescribed types of rates of merchant transactions:
TT (buying)- clean inward remittances
Bill (buying)- purchase/discount of export bills
TT (selling) clean outward remittances
Bill (selling) remittance for import bills

26. RBI/FEDAI Guidelines (1)
RBI has issued Authorised Dealers (AD) licences to banks, all India financial institutions and a few co-operative banks to undertake foreign exchange transactions in India
It has also issued Money Changer licences to a large number of established firms, companies, hotels, shops, etc.

27. RBI/FEDAI Guidelines (2)
Money changers help facilitate encashment of foreign currencies of foreign tourists
Entities authorised to buy and sell foreign currency notes, coins and travellers’ cheques are called full fledged money changers
Those authorised only to buy are called restricted money changers

28. RBI/FEDAI Guidelines (3)
FEDAI (Foreign Exchange Dealers’ Association of India) is a non-profit making body formed in 1958 with the approval of RBI
Its members are authorised dealers and it prescribes guidelines and rules of the game for market operations, merchant rates, quotations, delivery dates, holidays, interest on defaults, etc.
FEDAI also advises RBI on market related issues and supplements RBI on strengthening the market