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Role of RBI in FOREX

Market
Prof. Shegorika

6/19/2009
Submitted by:
Mayank Agarwal
(46)
Sujay Kr. Tiwari
( )
Puneet Chaurasia
(59)
Gopal Saxena
(26)
Shishir Kumar
(71)
Shobhit Asthana
( )

Introduction
The Indian FOREX market owes its origin to the important
step that RBI took in 1978 to allow banks to undertake intra-
day trading in foreign exchange. As a consequence, the
stipulation of maintaining “Square” or “near square” position
was to be complied with only at the close of business each
day. During the period 1975-1992, the exchange rate of rupee
was officially determined by the RBI in terms of a weighted
basket of currencies of India’s major trading partners and
there were significant restrictions on the current account
transactions.
The initiation of economic reforms in July 1991 saw
significant two-step downward adjustment in the exchange
rate of the rupee on July 1 and 3, 1991 with a view to placing
it at an appropriate level in line with the inflation differential
to maintain the competitiveness of exports. Subsequently,
following the recommendations of the High Level Committee
on Balance of Payments (Chairman:Dr C. Rangarajan) the
Liberalised Exchange Rate Management System(LERMS)
involving dual exchange rate mechanism was instituted in
March 1992 which was followed by the ultimate convergence
of the dual rates effective from March 1, 1993(christened
modified LERMS). The unification of the exchange rate of the
rupee marks the beginning of the era of market determined
exchange rate regime of rupee, based on demand and supply
in the forex market. It is also an important step in the progress
towards current account convertibility, which was finally
achieved in August 1994 by accepting Article VIII of the
Articles of Agreement of the International Monetary Fund.

Exchange Rate
Exchange Rate is the price of one country's currency
expressed in another country's currency. In other words, the
rate at which one currency can be exchanged for another. e.g.
Rs. 48.50 per one USD.

Major currencies of the World


➢ USD
➢ EURO
➢ YEN
➢ POUND STERLING

What is a Foreign Exchange


Transaction ?
➢ Any financial transaction that involves more than
one currency is a foreign exchange transaction.

➢ Most important characteristic of a foreign exchange


transaction is that it involves Foreign Exchange
Risk.

Types Of Exchange Rates

There are 4 types of Exchange rates:


1. Ready
2. Value Tom
3. Spot Transaction
4. Forward Transaction

1) Ready: Settlement of funds on the same day (date of


the deal).
2) Value Tom: Settlement of funds takes place on the
next working day of the date of the deal.
3) Spot Transaction: Settlement of funds takes place
on the second working day following the date of the
deal.
4) Forward Transaction: Delivery takes place on any
day after the date of the deal.

What Does Price Maker Mean?


A monopoly or a firm within monopolistic
competition that has the power to influence the price it
charges as the good it produces does not have perfect
substitutes.

Investopedia explains Price Maker


A monopoly is a price maker as it holds a large amount of
power over the price it charges.

A price maker that is a firm within monopolistic competition


produces goods that are differentiated in some way from its
competitors' products. This kind of price maker is also a
profit-maximizer as it will increase output only as long as its
marginal revenue is greater than its marginal cost, in other
words, as long as it's producing a profit.

What Does Price-Taker Mean?


1. An investor who’s buying or selling transactions are
assumed to have no effect on the market.
2. A firm that can alter its rate of production and sales without
significantly affecting the market price of its product.

Investopedia explains Price-Taker


1. In the context of the stock market, individual investors are
price-takers.
2. Suppose you sell water, which of course is supplied by
millions of other places, including the sky. If you decide to set
the price of a gallon of your water at $10, you will likely sell
nothing because this commodity is readily available elsewhere
for a much cheaper price.
The main purpose of the foreign currency exchange market is
to make money but it is different from other equity markets.
There are various technical terminologies and strategies a
trader must know to deal with currency exchange. In the
Currency Exchange market the commodity that is traded is
the foreign currency. These foreign currencies are always
priced in pairs. The value of one unit of a foreign currency is
always expressed in terms of another foreign currency. Thus
all trades incorporate the purchase and sale of two foreign
currencies at the same time. You have to buy a currency only
when you expect the value of that currency to increase in the
future.
They are always quoted in pairs as USD/JPY. The first
currency is the base currency and the second one is the quote
currency. The quote value depends on the currency conversion
rates between the two currencies under consideration. Mostly
the USD will be used as based currency but sometimes euro,
pound sterling is also used.
The profit of the broker depends on the bid and the ask
price. The bid is the price the broker is ready to pay to buy
base currency for exchanging the quote currency. The ask is
the price the broker is ready to sell the base currency for
exchanging the quote currency. The difference between these
two prices is called the spread which determines the profit or
loss of the trade.
RATE QUOTATION CONVENTIONS:
An exchange system quotation is given by stating the number of units
of "term currency" (or "price currency" or "quote currency") that can
be bought in terms of 1 "unit currency" (also called "base currency").
For example, in a quotation that says the EURUSD exchange rate is
1.4320 (1.4320 USD per EUR), the term currency is USD and the
base currency is EUR.
There is a market convention that determines which is the base
currency and which is the term currency. In most parts of the world,
the order is: EUR – GBP – AUD – NZD – USD – others. Thus if you
are doing a conversion from EUR into AUD, EUR is the base
currency, AUD is the term currency and the exchange rate tells you
how many Australian dollars you would pay or receive for 1 Euro.
Cyprus and Malta which were quoted as the base to the USD and
others were recently removed from this list when they joined the
Euro. In some areas of Europe and in the non-professional market in
the UK, EUR and GBP are reversed so that GBP is quoted as the base
currency to the euro. In order to determine which the base currency is
where both currencies are not listed (i.e. both are "other"), market
convention is to use the base currency which gives an exchange rate
greater than 1.000. This avoids rounding issues and exchange rates
being quoted to more than 4 decimal places. There are some
exceptions to this rule e.g. the Japanese often quote their currency as
the base to other currencies.
Quotes using a country's home currency as the price currency (e.g.,
EUR 0.63 = USD 1.00 in the euro zone) are known as direct quotation
or price quotation (from that country's perspective) [1] and are used
by most countries.
Quotes using a country's home currency as the unit currency (e.g.,
EUR 1.00 = USD 1.58 in the euro zone) are known as indirect
quotation or quantity quotation and are used in British newspapers
and are also common in Australia, New Zealand and the Euro zone.

1. DIRECT QUOTATION:
Direct quotation: 1 foreign currency unit = x home currency units
“Price of one Unit of Domestic Currency in terms of Foreign Currency”
Five Currencies are quoted in Direct Terms
) Pound Sterling
2) Euro
3) Australian Dollar
4) New Zealand Dollar
5) Irish Punt

2. IN-DIRECT QUOTATION:
“Price of one Unit of Foreign Currency in terms of Domestic
Currency”
Indirect quotation: 1 home currency unit = x foreign currency
units
In the international market, almost all currencies are quoted indirectly.
Note that, using direct quotation, if the home currency is
strengthening (i.e., appreciating, or becoming more valuable) then the
exchange rate number decreases. Conversely if the foreign currency is
strengthening, the exchange rate number increases and the home
currency is depreciating.
Market convention from the early 1980s to 2006 was that most
currency pairs were quoted to 4 decimal places for spot transactions
and up to 6 decimal places for forward outrights or swaps. (The fourth
decimal place is usually referred to as a "pip.") An exception to this
was exchange rates with a value of less than 1.000 which were usually
quoted to 5 or 6 decimal places. Although there is no fixed rule,
exchange rates with a value greater than around 20 were usually
quoted to 3 decimal places and currencies with a value greater than 80
were quoted to 2 decimal places. Currencies over 5000 were usually
quoted with no decimal places (e.g. the former Turkish Lira). e.g.
(GBPOMR : 0.765432 - EURUSD : 1.5877 - GBPBEF : 58.234 -
EURJPY : 165.29). In other words, quotes are given with 5 digits.
Where rates are below 1, quotes frequently include 5 decimal places.
In 2005 Barclays Capital broke with convention by offering spot
exchange rates with 5 or 6 decimal places on their electronic dealing
platform. The contraction of spreads (the difference between the bid
and offer rates) arguably necessitated finer pricing and gave the banks
the ability to try and win transaction on multibank trading platforms
where all banks may otherwise have been quoting the same price. A
number of other banks have now followed this.
Risk Management and Settlement of Transactions in the Foreign
Exchange Market
➢ The foreign exchange market is characterized by constant changes
and rapid innovations in trading methods and products. While the
innovative products and ways of trading create new possibilities for
profit, they also pose various kinds of risks to the market. Central
banks all over the world, therefore, have become increasingly
concerned of the scale of foreign exchange settlement risk and the
importance of risk mitigation measures. Behind this growing
awareness are several events in the past in which foreign exchange
settlement risk might have resulted in systemic risk in global
financial markets, including the failure of Bankhaus Herstatt in
1974 and the closure of BCCI SA in 1991.
➢ The foreign exchange settlement risk arises because the delivery of
the two currencies involved in a trade usually occurs in two
different countries, which, in many cases are located in different
time zones. This risk is of particular concern to the central banks
given the large values involved in settling foreign exchange
transactions and the resulting potential for systemic risk. Most of
the banks in the EMEs use some form of methodology for
measuring the foreign exchange settlement exposure. Many of
these banks use the single day method, in which the exposure is
measured as being equal to all foreign exchange receipts that are
due on the day. Some institutions use a multiple day approach for
measuring risk. Most of the banks in EMEs use some form of
individual counterparty limit to manage their exposures. These
limits are often applied to the global operations of the institution.
These limits are sometimes monitored by banks on a regular basis.
In certain cases, there are separate limits for foreign exchange
settlement exposures, while in other cases, limits for aggregate
settlement exposures are created through a range of instruments.
Bilateral obligation netting, in jurisdictions where it is legally
certain, is an important way for trade counterparties to mitigate the
foreign exchange settlement risk. This process allows trade
counterparties to offset their gross settlement obligations to each
other in the currencies they have traded and settle these obligations
with the payment of a single net amount in each currency.

➢ Several emerging markets in recent years have implemented


domestic real time gross settlement (RTGS) systems for the
settlement of high value and time critical payments to settle the
domestic leg of foreign exchange transactions. Apart from risk
reduction, these initiatives enable participants to actively manage
the time at which they irrevocably pay way when selling the
domestic currency, and reconcile final receipt when purchasing the
domestic currency. Participants, therefore, are able to reduce the
duration of the foreign exchange settlement risk.

➢ Recognizing the systemic impact of foreign exchange settlement


risk, an important element in the infrastructure for the efficient
functioning of the Indian foreign exchange market has been the
clearing and settlement of inter-bank USD-INR transactions. In
pursuance of the recommendations of the Sodhani Committee, the
Reserve Bank had set up the Clearing Corporation of India Ltd.
(CCIL) in 2001 to mitigate risks in the Indian financial markets.
The CCIL commenced settlement of foreign exchange operations
for inter-bank USD-INR spot and forward trades from November
8, 2002 and for inter-bank USD-INR cash and tom trades from
February 5, 2004. The CCIL undertakes settlement of foreign
exchange trades on a multilateral net basis through a process of
notation and all spot, cash and tom transactions are guaranteed for
settlement from the trade date. Every eligible foreign exchange
contract entered between members gets notated or replaced by two
new contracts – between the CCIL and each of the two parties,
respectively. Following the multilateral netting procedure, the net
amount payable to, or receivable from, the CCIL in each currency
is arrived at, member-wise. The Rupee leg is settled through the
members’ current accounts with the Reserve Bank and the USD leg
through CCIL’s account with the settlement bank at New York. The
CCIL sets limits for each member bank on the basis of certain
parameters such as member’s credit rating, net worth, asset value
and management quality. The CCIL settled over 900,000 deals for
a gross volume of US $ 1,180 billion in 2005-06. The CCIL has
consistently endeavoured the entire gamut of foreign exchange
transactions under its purview. Intermediation, by the CCIL thus,
provides its members the benefits of risk mitigation, improved
efficiency, lower operational cost and easier reconciliation of
accounts with correspondents.

➢ An issue related to the guaranteed settlement of transactions by the


CCIL has been the extension of this facility to all forward trades as
well. Member banks currently encounter problems in terms of huge
outstanding foreign exchange exposures in their books and this
comes in the way of their doing more trades in the market. Risks
on such huge outstanding trades were found to be very high and so
were the capital requirements for supporting such trades. Hence,
many member banks have expressed their desire in several fora
that the CCIL should extend its guarantee to these forward trades
from the trade date itself which could lead to significant increase in
the liquidity and depth in the forward market. The risks that banks
today carry in their books on account of large outstanding forward
positions will also be significantly reduced (Gopinath, 2005). This
has also been one of the recommendations of the Committee on
Fuller Capital Account Convertibility.

➢ Apart from managing the foreign exchange settlement risk,


participants also need to manage market risk, liquidity risk, credit
risk and operational risk efficiently to avoid future losses. As per
the guidelines framed by the Reserve Bank for banks to aligns and
exposure in derivative markets as market makers, the boards of
directors of ADs (category-I) are required to frame an appropriate
policy and fix suitable limits for operations in the foreign exchange
market. The net overnight open exchange position and the
aggregate gap limits need to be approved by the Reserve Bank. The
open position is generally measured separately for each foreign
currency consisting of the net spot position, the net forward
position, and the net options position. Various limits for exposure,
viz., overnight, daylight, stop loss, gap limit, credit limit, value at
risk (VaR), etc., for foreign exchange transactions by banks are
fixed. Within the contour of these limits, front office of the treasury
of ADs transacts in the foreign exchange market for customers and
own proprietary requirements. These exposures are accounted,
confirmed and settled by back office, while mid-office evaluates
the profit and monitors adherence to risk limits on a continuous
basis. In the case of market risk, most banks use a combination of
measurement techniques including and managed by most banks on
an aggregate counter-party basis so as to include all exposures in
the underlying spot and derivative markets. Some banks also
monitor country risk through cross-border country risk exposure
limits. Liquidity risk is generally estimated by monitoring asset
liability profile in various currencies in various buckets and
monitoring currency-wise gaps in various buckets. Banks also track
balances to be maintained on a daily basis in Nostro accounts,
remittances and committed foreign currency term loans while
monitoring liquidity risk.

➢ To sum up, the foreign exchange market structure in India has


undergone substantial transformation from the early 1990s. The
market participants have become diversified and there are several
instruments available to manage their risks. Sources of supply and
demand in the foreign exchange market have also changed in line
with the shifts in the relative importance in balance of payments
from current to capital account. There has also been considerable
improvement in the market infrastructure in terms of trading
platforms and settlement mechanisms. Trading in Indian foreign
exchange market is largely concentrated in the spot segment even
as volumes in the derivatives segment are on the rise. Some of the
issues that need attention to further improve the activity in the
derivatives segment include flexibility in the use of various
instruments, enhancing the knowledge and understanding the
nature of risk involved in transacting the derivative products,
reviewing the role of underlying in booking forward contracts and
guaranteed settlements of forwards. Besides, market players would
need to acquire the necessary expertise to use different kinds of
instruments and manage the risks involved.