TABLE OF CONTENTS

INTRODUCTION.......................................................................................................................................1
REER AND NEER..................................................................................................................................3
SCOPE OF STUDY................................................................................................................................4
LIMITATIONS.......................................................................................................................................5
METHOD OF DATA COLLECTION....................................................................................................5
MAIN TEXT...............................................................................................................................................6
Reading a Quote......................................................................................................................................6
Cross Currency........................................................................................................................................7
Bid and Ask.............................................................................................................................................8
The types of rates as are as follows:........................................................................................................9
Spreads and Pips....................................................................................................................................10
An overview of the Forex currency trading and currency derivative transactions involved in hedging. 12
Derivatives............................................................................................................................................13
Currency Pairs in the Forwards and Futures Markets............................................................................17
Spot Market and the Forwards and Futures Markets.............................................................................18
Main regulations governing FX.............................................................................................................21
Operational risks....................................................................................................................................22
Appropriateness.....................................................................................................................................23
Termsheets............................................................................................................................................23
FINDINGS................................................................................................................................................25
I. SNAPSHOTS OF SYSTEMS IN THE DEALING ROOM...........................................................25
II. METHOD OF DETERMINING PRICES AS PER THE TRANSACTIONS................................33
III. CLIENT CLASSIFICATION....................................................................................................37

1
INTRODUCTION

The topic for my project is global market rates and foreign exchange. The study
includes about the methods adopted in pricing the various transactions by Standard
Chartered Bank, in global markets. To be more precise it deals with the foreign
exchange transactions including the hedging part which are being practiced by the
treasury department.

This project will not only help me to expand my domain knowledge but also to
have a fair idea about the practical aspects of these operations which are held. It
has given me a fair idea of what hedging is and the ways by which risk is being
managed through the hedge instruments. It also teaches how a very small price
fluctuation in the rates can yield profits or put into losses.

The foreign exchange market (forex or FX in short) is one of the most exciting,
fast-paced markets around.
The daily currency fluctuations are generally very small. Most currency pairs move
less than one cent per day, representing a less than 1% change in the value of the
currency. This makes foreign exchange one of the least volatile financial markets
around. Therefore, many currency speculators rely on the availability of enormous
leverage to increase the value of potential movements. In the retail forex market,
leverage can be as much as 250:1. Higher leverage can be extremely risky, but
because of round-the-clock trading and deep liquidity, foreign exchange brokers
have been able to make high leverage an
industry standard in order to make the movements meaningful for currency traders.

Extreme liquidity and the availability of high leverage have helped to spur the
market's rapid growth and made it the ideal place for many traders. Positions can
be opened and closed within minutes or can be held for months. Currency prices
are based on objective considerations of supply and demand and cannot be

2
manipulated easily because the size of the market does not allow even the largest
players, such as central banks, to move prices at will.

The forex market provides plenty of opportunity for investors. However, in order
to be successful, a currency trader has to understand the basics behind currency
movements.

There are many macroeconomic factors which regulate the movement of the
exchange rates namely, GDP, balance of payments, investment flows, inflation,
interest rates, central bank regulation and psychological factors.

A growth in the GDP of a country will strengthen its currency. An increase in

exports of a country implies a higher demand for the local currency, which in turn
appreciates the exchange rate of the currency. The investment flows is driven by
the investing decisions taken by mutual funds, foreign institutional investors, non-
residents, banking system and central banks. Higher investment returns lure global
investors towards growing economies. This leads to a huge demand for local
currency leading to an appreciation in its value.

A country’s inflation has a significant impact on its exchange rate. Assuming the
inflation rate of other countries to be constant/zero, as the rate of inflation of a
country increases, prices are comparatively higher, which deters exports and
encourages imports. This puts the downward pressure on the exchange rate of the
country. Also, purchasing power parity implies that the exchange rate between two
currencies adjusts to the rates of inflation in the two countries. It is intended to
equalize the purchasing power of the two currencies.

An increase in the interest rates of a country encourages foreign investment, which

results in an increase for the demand of the local currency, which in turn makes the
currency stronger. The opposite is true for a fall in interest rates. The interest rate
parity condition implies that the exchange rate between two currencies will
incorporate the interest rate differential between the two currencies such that no
arbitrage exists.

3
Central bank regulation: Very often central banks control the exchange rates
environment to manage the forex reserves and the BOP situation of the country. In
such a case, the Central Bank will buy Dollars and sell the local currency when the
exchange rate is appreciating and sell dollars vs. the local currency when the
exchange rate is depreciating. This also helps to keep the exports competitive.

There are many psychological factors which regulate the exchange rates.
Whenever there is a discrepancy between previously held expectations and the
actual outcome, the currency gets affected adversely. This could be triggered by
data on economic indicators released by government. Herd mentality among
market makers might defy economic logic and tend to move the currency against
market force. Speculation and arbitrage activities by speculators can make the
market move against economic logic. Market players are able to move the market
by taking up very large positions.

REER AND NEER

Real effective exchange rate [REER]: The weighted average of a country’s

currency relative to an index or basket of other major currencies adjusted for the
effects of inflation. The weights are determined by comparing the relative trade
balances, in terms of one country’s currency, with every other country within the
index.

Nominal effective exchange rate [NEER]: The unadjusted weighted average value
of a country’s currency relative to all major currencies being traded within an
index or pool of currencies. The currencies typically used are US dollar, Japanese
Yen, Euro etc.

Foreign exchange deals with the exchange of currencies and foreign exchange rate
is the price of one currency expressed in terms of another currency. In short it is
the price of switching or swapping between currencies. Foreign exchange not only

4
deals with currency exchange, it is also used in hedging purposes which is a
method of risk protection.

Risk in foreign exchange is the risk of loss arising due to an adverse movement in
exchange rates. At a macro level, adverse movements in currencies can impact the
balance of payments position of that country. Hence, a foreign exchange risk
management is used by corporate to evaluate their exposure to risk and hedge the
exposure accordingly. Hedging can be done using derivatives which are financial
instruments that derives its value from the underlying assets. The underlying assets
could be commodities, shares, bonds, interest rates, stock indices, exchange rates
or even intangibles. The main types of derivatives are futures, forwards, options
and swaps.

SCOPE OF STUDY

The scope of study was huge because I worked in a field which was very new and
it gave me a vent to know a lot about the subject treasury which I am sure will help
me in the long run. Not only that, terms like foreign exchange, hedging, global
markets etc. were all new but now I have some idea about these fields and how it
really helps the corporate for their profit leverage. The movement of foeign
exchange rates was another field which could be studied as well.

Working with the dealers really gave me a very good exposure.

5
LIMITATIONS

1. The basic practical limitation which I faced was this that since I was in the
dealing room hence the dealers were very busy. This took me a lot of time to
know about the operations.
2. Since the amount for which they hedge is lump sum hence I could not have
in-hand experience on that.
3. Banking security issues did not permit to provide me with sufficient data.

METHOD OF DATA COLLECTION

The data collected regarding the systems that are involved in pricing was given to
me by the bank authority. So I had gone through the real life case -lets given to me
to collect the data suitable for my project.

6
MAIN TEXT
One of the biggest sources of confusion for those new to the currency market is the
standard for quoting currencies. The currency quotations and how they work in
currency pair trades is as follows:

Reading a Quote

When a currency is quoted, it is done in relation to another currency, so that the

value of one is reflected through the value of another. Therefore, if you are trying
to determine the exchange rate between the U.S. dollar (USD) and the Japanese
yen (JPY), the forex quote would look like this:

USD/JPY = 119.50

This is referred to as a currency pair. The currency to the left of the slash is the
base currency, while the currency on the right is called the quote or counter
currency. The base currency (in this case, the U.S. dollar) is always equal to one
unit (in this case, US$1), and the quoted currency (in this case, the Japanese yen) is
what that one base unit is equivalent to in the other currency. The quote means that
US$1 = 119.50 Japanese yen. In other words, US$1 can buy 119.50 Japanese yen.
The forex quote includes the currency abbreviations for the currencies in question.

Direct Currency Quote vs. Indirect Currency Quote

There are two ways to quote a currency pair, either directly or indirectly. A direct
currency quote is simply a currency pair in which the domestic currency is the base
currency; while an indirect quote, is a currency pair where the domestic currency is
the quoted currency. So if you were looking at the Canadian dollar as the domestic
currency and U.S. dollar as the foreign currency, a direct quote would be
CAD/USD, while an indirect quote would be USD/CAD. The direct quote varies
7
the foreign currency, and the quoted, or domestic currency, remains fixed at one
unit. In the indirect quote, on the other hand, the domestic currency is variable and
the foreign currency is fixed at one unit.

For example, if Canada is the domestic currency, a direct quote would be 0.85
CAD/USD, which means with C$1, you can purchase US$0.85. The indirect quote
for this would be the inverse (1/0.85), which is 1.18 USD/CAD and means that
USD$1 will purchase C$1.18.

In the forex spot market, most currencies are traded against the U.S. dollar, and the
U.S. dollar is frequently the base currency in the currency pair. In these cases, it is
called a direct quote. This would apply to the above USD/JPY currency pair,
which indicates that US$1 is equal to 119.50 Japanese yen.

However, not all currencies have the U.S. dollar as the base. The Queen's
currencies - those currencies that historically have had a tie with Britain, such as
the British pound, Australian Dollar and New Zealand dollar - are all quoted as the
base currency against the U.S. dollar. The euro, which is relatively new, is quoted
the same way as well. In these cases, the U.S. dollar is the counter currency, and
the exchange rate is referred to as an indirect quote. This is why the EUR/USD
quote is given as 1.25, for example, because it means that one euro is the
equivalent of 1.25 U.S. dollars.

Most currency exchange rates are quoted out to four digits after the decimal place,
with the exception of the Japanese yen (JPY), which is quoted out to two decimal
places.

Cross Currency

When a currency quote is given without the U.S. dollar as one of its components,
this is called a cross currency. The most common cross currency pairs are the
EUR/GBP, EUR/CHF and EUR/JPY. These currency pairs expand the trading
possibilities in the forex market, but it is important to note that they do not have as
much of a following (for example, not as actively traded) as pairs that include the
U.S. dollar, which also are called the majors.

8
Bid and Ask

As with most trading in the financial markets, when you are trading a currency pair
there is a bid price (buy) and an ask price (sell). Again, these are in relation to the
base currency. When buying a currency pair (going long), the ask price refers to
the amount of quoted currency that has to be paid in order to buy one unit of the
base currency, or how much the market will sell one unit of the base currency for
in relation to the quoted currency.

The bid price is used when selling a currency pair (going short) and reflects how
much of the quoted currency will be obtained when selling one unit of the base
currency, or how much the market will pay for the quoted currency in relation to
the base currency.

The quote before the slash is the bid price, and the two digits after the slash
represent the ask price (only the last two digits of the full price are typically
quoted). The bid price is always smaller than the ask price. Let's look at an
example:

USD/CAD = 1.2000/05
Bid = 1.2000
Ask= 1.2005

If we want to buy this currency pair, this means that we intend to buy the base
currency and are therefore looking at the ask price to see how much (in Canadian
dollars) the market will charge for U.S. dollars. According to the ask price, we can
buy one U.S. dollar with 1.2005 Canadian dollars.

However, in order to sell this currency pair, or sell the base currency in exchange
for the quoted currency, we would look at the bid price. It tells us that the market
will buy US$1 base currency (we will be selling in market the base currency) for a
price equivalent to 1.2000 Canadian dollars, which is the quoted currency.

Whichever currency is quoted first (the base currency) is always the one in which
the transaction is being conducted. We either buy or sell the base currency.

Depending on what currency we want to use to buy or sell the base with, we refer
to the corresponding currency pair spot exchange rate to determine the price.
9
The types of rates as are as follows:

Basically it is divided into two categories one is for the bank and the other is for
the retail transactions.

The rates which are classified according for the bank are as follows:

 Spot rate: it is the rate currently prevailing in the market. It is the rate
quoted today for delivery after 2 working days.
T+2 is a market convention followed globally.
 Cash rate: It is the rate offered for today i.e. T+0 or (T+2)-2 or spot 2
days.
 Tom rate: It is the T+1 rate.

Example
If today is August 7, 2006
Then Cash: August 7, 2006
Tom: August 8, 2006
Spot: August9, 2006

 Cross rates: a cross rate relative to INR is any rate other than
USD/INR

For the retail transactions the rates are classified as follows:

10
 - For merchant transaction
- Chord rate
- Spot: used when the NOSTRO account has been credited or debited already.
- An A/c in F/c in the country of currency i.e. USD account in US
- Bills: for transactions where the amount will be credited or debited at a later
date
- Tc: travelers cheque

Spreads and Pips

The difference between the bid price and the ask price is called a spread.

If we were to look at the following quote: EUR/USD = 1.2500/03, the spread

would be 0.0003 or 3 pips, also known as points. Although these movements may
seem insignificant, even the smallest point change can result in thousands of
dollars being made or lost due to leverage. Again, this is one of the reasons that
speculators are so attracted to the forex market; even the tiniest price movement
can result in huge profit.

The pip is the smallest amount a price can move in any currency quote. In the case
of the U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001.
With the Japanese yen, one pip would be 0.01, because this currency is quoted to
two decimal places. So, in a forex quote of USD/CHF, the pip would be 0.0001
Swiss francs. Most currencies trade within a range of 100 to 150 pips a day.
11
Currency Quote Overview
USD/CAD = 1.2232/37
Base Currency Currency to the left (USD)
Quote/Counter
Currency to the right (CAD)
Currency
Price for which the market
maker will buy the base
Bid Price 1.2232
currency. Bid is always
smaller than ask.
Price for which the market
Ask Price 1.2237 maker will sell the base
currency.
One point move, in USD/CAD
it is .0001 and 1 point change The pip/point is the smallest
Pip
would be from 1.2231 to movement a price can make.
1.2232
Spread in this case is 5
pips/points; difference
Spread
between bid and ask price
(1.2237-1.2232).

Basically Standard Chartered Bank offers the following

products to its wholesale banking customers which are
as follows:
1. FX
a) Spot FX
i) USD/INR
ii) Cross-currencies

12
 b) Forward FX

2. DERIVATIVES
a) FX options
b) Interest rate derivatives
i) Swaps
ii) Interest rate options
iii) FRAs
c) Commodity derivatives
d) Alternate assets

3. Structured products

An overview of the Forex currency trading and

currency derivative transactions involved in
hedging

The foreign exchange market is the "place" where currencies are traded. Currencies
are important to most people around the world, whether they realize it or not,
because currencies need to be exchanged in order to conduct foreign trade and
business. If we are living in the U.S. and want to buy cheese from France, either
me or the company that I buy the cheese from has to pay the French for the cheese
in Euros (EUR). This means that the U.S. importer would have to exchange the
equivalent value of U.S. dollars (USD) into Euros. The same goes for traveling. A
French tourist in Egypt cannot pay in Euros to see the pyramids because it's not the
locally accepted currency. As such, the tourist has to exchange the Euros for the
local currency, in this case the Egyptian pound, at the current exchange rate.

13
The need to exchange currencies is the primary reason why the forex market is the
largest, most liquid financial market in the world. It dwarfs other markets in size,
even the stock market, with an average traded value of around U.S. $2,000 billion
per day. (The total volume changes all the time, but as of April 2004, the Bank for
International Settlements (BIS) reported that the forex market traded U.S. $1,900
billion per day.)

One unique aspect of this international market is that there is no central

marketplace for foreign exchange. Rather, currency trading is conducted
electronically over-the-counter (OTC), which means that all transactions occur via
computer networks between traders around the world, rather than on one
centralized exchange. The market is open 24 hours a day, five and a half days a
week, and currencies are traded worldwide in the major financial centers of
London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and
Sydney - across almost every time zone. This means that when the trading day in
the U.S. ends, the forex market begins anew in Tokyo and Hong Kong. As such,
the forex market can be extremely active any time of the day, with price quotes
changing constantly.

Derivatives
A derivative is a financial instrument, which derives its value from the underlying
asset. Underlying assets could be commodities, shares, bonds, interest rates, stock
indices, exchange rates or even intangibles. The main type of derivatives are
futures, forwards, options and swaps.

14
The main types of derivatives used for the purpose of
hedging are futures, forwards, options and swaps.

Forwards:
A forward contract is an agreement between two parties entered in advance to
buy/sell forex for a pre-determined future date at a pre-determined rate. So the rate
at which the transaction is carried out is called the outright forward rate. Forwards
are primarily booked with an objective to hedge foreign exchange risk.

Futures:
A currency futures contract, like a forward contract is a contract for future delivery
of a specified currency against the other, i.e. an agreement between two parties to
exchange one currency for another, with the actual exchange taking place at a
specified date at the future but the exchange rate being fixed at the time the
agreement is entered into. However, there are a number of significant differences
between the forwards and the futures. These relate to contract features, the way the

15
markets are organized, profiles of gains and losses, kinds of participants in the
markets and the way in which they use the two instruments.

Marking to market: one of the most important features which fall under the futures
is the marking to market or the MTM. It essentially means that at the end of the
trading session, all outstanding contracts are re-priced at the settlement price of
that session. Margin accounts of those who have made losses are debited while
those who gained are credited.

Options:
An option is a contract which gives the buyer [holder] of the option:

-the right but not the obligation

-to buy or to sell an agreed amount of financial instrument [call/put]
-on or before an agreed future date[expiry]
-at an agreed price[strike]
-in exchange for a fee

Parties involved in an option contract: There are two parties to an option

contract, the buyer [holder] and the seller [writer]. The buyers have a right whereas
the sellers only have an obligation. The buyers are the payers of the premium
whereas the sellers are the receivers of the premium.

What are call or put option? The two basic types of options are:

- Put option: right to sell

- Call option: right to buy

A put option gives the holder the right to sell an asset at a pre-determined price
[strike price]. If the spot price at expiry is below the strike price, the holder can
exercise his option and sell at this higher price.

16
A call option gives the holder the right to purchase at a pre-determined price [strike
price]. If the spot price at expiry is above the strike price, the holder can exercise
his option to purchase at a lower price. The writer of the option is obligated to sell
at this lower price.

Kinds of options:

- European options: these options can only be exercised at the expiry date of
the option
- American options: these options can be exercised at any time prior to, and
including expiry date of the option.
- Bermudan options: these options can be exercised on pre-specified days
during the life of the option.

Swaps:
A swap is a derivative, where two counterparties exchange one stream of cash
flows against another stream. These streams are called the legs of the swap. The
cash flows are calculated over the notional principal amount. Swaps are often used
to hedge certain risks, for instance interest rate risk. The interest rate and cross
currency swaps are to be focused here.

Interest rate swap: under an interest rate swap, a party converts its fixed rate loan
into a floating rate loan or vice -versa. This is normally undertaken in the same
currency.

Example: the client borrows 1 million USD @10% p.a. for 6 years. However he
expects interest rates to fall over the next few years. The client will enter into the

17
interest rate swap with the bank in which he will pay the bank a floating rate [e.g.
LIBOR] and in turn the bank will pay him a fixed rate, which the client will use to
pay the initial lender.

Cross currency swap: under a CCS, cash flows in one currency are converted into
the cash flows in another currency at an agreed rate for an agreed period of time.
This works both as hedging and a cost reduction strategy. The kinds of cross-
currency swaps are total currency swap, coupon-only swap and principal-only
swap.

What are swap points?

Currencies are quoted in spot values or for delivery on a T+2 basis, while the
actual delivery might be required for any other day. Swap points are added or
subtracted to the spot rates to arrive at the rate for the specific date of delivery.
They are also quoted in the market on an OTC basis. Thus, cash, tom, and forward
rates are nothing but spot rates plus/minus swap points.

Currency Pairs in the Forwards and Futures Markets

One of the key technical differences between the forex markets is the way
currencies are quoted. In the forwards or futures markets, foreign exchange is
always quoted against the U.S. dollar. This means that pricing is done in terms of
how many U.S. dollars are needed to buy one unit of the other currency. It is to be
remembered that in the spot market some currencies are quoted against the U.S.
dollar, while for others, the U.S. dollar is being quoted against them. As such, the
18
forwards/futures market and the spot market quotes will not always be parallel to
one another.

For example, in the spot market, the British pound is quoted against the U.S. dollar
as GBP/USD. This is the same way it would be quoted in the forwards and futures
markets. Thus, when the British pound strengthens against the U.S. dollar in the
spot market, it will also rise in the forwards and futures markets.

On the other hand, when looking at the exchange rate for the U.S. dollar and the
Japanese yen, the former is quoted against the latter. In the spot market, the quote
would be 115 for example, which means that one U.S. dollar would buy 115
Japanese yen. In the futures market, it would be quoted as (1/115) or .0087, which
means that 1 Japanese yen would buy .0087 U.S. dollars. As such, a rise in the
USD/JPY spot rate would equate to a decline in the JPY futures rate because the
U.S. dollar would have strengthened against the Japanese yen and therefore one
Japanese yen would buy less U.S. dollars.

Spot Market and the Forwards and Futures Markets

There are actually three ways that institutions, corporations and individuals trade
forex: the spot market, the forwards market and the futures market. The forex
trading in the spot market always has been the largest market because it is the
"underlying" real asset that the forwards and futures markets are based on. In the
past, the futures market was the most popular venue for traders because it was
available to individual investors for a longer period of time. However, with the
advent of electronic trading, the spot market has witnessed a huge surge in activity
and now surpasses the futures market as the preferred trading market for individual
investors and speculators. When people refer to the forex market, they usually are
referring to the spot market. The forwards and futures markets tend to be more
popular with companies that need to hedge their foreign exchange risks out to a

19
specific date in the future.

What is the spot market?

More specifically, the spot market is where currencies are bought and sold
according to the current price. That price, determined by supply and demand, is a
reflection of many things, including current interest rates, economic performance,
sentiment towards ongoing political situations (both locally and internationally), as
well as the perception of the future performance of one currency against another.
When a deal is finalized, this is known as a "spot deal". It is a bilateral transaction
by which one party delivers an agreed-upon currency amount to the counter party
and receives a specified amount of another currency at the agreed-upon exchange
rate value. After a position is closed, the settlement is in cash. Although the spot
market is commonly known as one that deals with transactions in the present
(rather than the future), these trades actually take two days for settlement.

What are the forwards and futures markets?

Unlike the spot market, the forwards and futures markets do not trade actual
currencies. Instead they deal in contracts that represent claims to a certain currency
type, a specific price per unit and a future date for settlement.

In the forwards market, contracts are bought and sold OTC between two parties,
who determine the terms of the agreement between themselves.

In the futures market, futures contracts are bought and sold based upon a standard
size and settlement date on public commodities markets, such as the Chicago
Mercantile Exchange. In the U.S., the National Futures Association regulates the
20
futures market. Futures contracts have specific details, including the number of
units being traded, delivery and settlement dates, and minimum price increments
that cannot be customized. The exchange acts as a counterpart to the trader,
providing clearance and settlement.

Both types of contracts are binding and are typically settled for cash for the
exchange in question upon expiry, although contracts can also be bought and sold
before they expire. The forwards and futures markets can offer protection against
risk when trading currencies. Usually, big international corporations use these
markets in order to hedge against future exchange rate fluctuations, but speculators
take part in these markets as well.

What are time option contracts?

A time option contract is a forwards contract with the difference that it allows the
customer to settle the contract within a period of time rather than a particular date.

Example: A customer wants to book USD exports for December. Current spot on
31 August USD/INR is 46.50. December premium 20 paisa, November premium
16 paisa

21
Main regulations governing FX

Inter -bank foreign exchange dealings

The Board of directors of authorized dealers should frame an appropriate policy
and fix suitable limits for various treasury functions. The net overnight open
exchange position and the aggregate gap limits are required to be approved by the
Reserve Bank.

Authorized dealers may undertake foreign exchange transactions as under:

a.) With authorized dealers category- I in India :

- Buying/selling/swapping foreign currency against rupees or another foreign
currency
- Placing/accepting deposits and borrowing/lending in foreign currency

b.) With banks overseas and off-shore banking units in Special Economic
Zones:
- Buying/selling /swapping foreign currency against another foreign currency
to cover client transactions or for adjustment of own position
- Initiating trading positions in the overseas markets

Important regulations related to forex trading laid down

by the RBI are as follows:
- Past performance can be used to book FX exposures
- Past performance is higher of :
o Average annual import/export turnover for last three financial years or
o Previous financial year’s import/export turnover

22
 - Given a USD import/export exposure a corporate can buy/sell the USD
against any third currency, cancel and rebook
- Cancellation and rebooking crosses are permitted for corporate provided
they have underlying exposures
- Banks and financial institutions can do swaps purely on a hedged basis
without any impact on the spot market
- The open position on a swap book is restricted to $10 million per bank. This
has resulted in market volumes falling below $100 million.

Operational risks

Operational risk [OR] is defined as the risk of direct or indirect loss resulting from
inadequate or failed internal processes, people and systems or from external events.
BIS includes legal risk and strategic or reputational risk, if the cause is operational.
Under the Basle 2 norms, banks will be required o maintain capital against
operational risk. This will have a direct bearing on the pricing of products.

Standard Chartered bank’s policy on operational risk

Operational risk management assurance [ORMA] is the framework within which
the bank manages its operational risk. It is based on the three lines of defense- the
business, compliance, and audit.

23
Appropriateness

“Appropriateness” is a combination of many factors, the most important of which

are that:

- The customer understands the terms and mechanics of the transaction, and
the risks involved
- The transaction is within the customer’s powers and conforms to any general
policy or strategy adopted by the customer
- The transaction meets the customer’s objectives and
- The transaction is consistent with the customer’s appetite for risk.

This concept applies to all kinds of clients and covers all products. However, the
detailed requirements of the appropriateness procedures apply on a risk basis.
These apply to GM sales units, relationship managers and credit officers.

Termsheets

Termsheets are written documents that are tailored to each client and are provided
to a client before a transaction is executed. Termsheets contain the following
information:

1. A description of the product or structure

2. The purpose of the product or structure
3. Indicative terms and conditions applicable to the product or structure
4. An explanation of the factors likely to affect the value and how they may
do so(sensitivity analysis)
5. The risks inherent in the product or structure and
6. Indicative prices, dates and amounts for the proposed transaction.

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When to issue termsheets:
Client category Transaction color code When term sheets must be
sent to the clients
1 Green Not required

Red Every transaction

2 Green First product/structure of
that type only

Red Every transaction

3 Green First product /structure of
that type only

Red Every transaction

Trading hours for forex in India

The trading hours for spot trades on rupee are Monday to Friday 9a.m. till 5 p.m.
for forward trades on rupee, the trading hours are Monday-Friday 10a.m till 5p.m.
currencies other than rupee can be traded with foreign counter parties at any time.

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FINDINGS

I. SNAPSHOTS OF SYSTEMS IN THE

DEALING ROOM

A. INDIA FX
A channel where all cash deals [deals settled at T+0] and utilizations for
USD/INR and crosses are priced.

The process
If a client has an export bill settlement today [he wants to sell dollars and buy
Indian rupees], he would need to take a rate for conversion from USD to INR from
the dealer. Once he has taken a rate he would fax the necessary documents to trade
operations team, who in their turn after getting the fax would put the deal on India
FX website. It would then be priced by the dealer according to the rates he would
have given the customer. At the end of each day all the deals priced on India FX
site flow into FEDS i.e. they get exported to FEDS.

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Pricing a deal in INDIAFX

Utilizations
Whenever a customer wants to utilize his already existing contract before the value
date, the subsequent transaction is reflected on India FX which has to be again
priced

Pricing a utilization
For example, the client has an existing contract which matures on 30th. November,
2007 of which he utilizes 1,00,0000 on 24th.October. Hence the client would pay
the difference of the forward rates between 24th.October and 30th November to the
bank.

B. FEDS: Front End Dealing System.

FEDS is an internal system used by the bank to input all the deals. Though FEDS
is the front office system, OPICS is the system used by back office where all deals
from FEDS get reflected. Each such deal is assigned a different number. Typically
a dealer would not know the OPICS number of a deal entered in FEDS.

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IMPORTANT ICONS USED WHILE PRICING THE
DEALS
1. Trade entry: the trade entry icon launches the DTE where all deals are
entered.
2. Position view: the position view displays positions, profits and margins.
3. Trade finder: trade finder is a specific deal search tool
4. List view: the list view is a single function deal blotter

CANCEL AND AMENDS REPORT

Every deal entered in FEDS when it undergoes a change is tracked by an audit
trail. Hence if any such deal is amended, cancelled or deleted etc. it gets reflected
in the cancel and amends report.

The dealer who amends the deal has to cite the reason for his amendment or
cancellation. This report is generated every-day.

CHECKLIST BEFORE ENTERING A DEAL IN

FEDS
-TYPE OF CONTRACT

-CURRENCY PAIR

-DIRECTION OF THE TRADE

-AMOUNT AND VALUE DATE

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-COUNTERPARTY ID

-SPLIT TRADE FOR CROSS CURRENCY PAIRS

-MEMO

-LIMITS

-NOTE FEDS NUMBER IN BLOTTER

THREE -WAY RECONCILIATION

This is a discipline which is strictly followed by dealers to minimize cases of
operational risk

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 BLOTTER CHECK

FEDS CHECK P&L RECONCILIATION

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 C. APEX

This is an in-house developed system that provides prices for various option types
and strategies. Each bank has its own pricing capabilities but underlying models
and component inputs used in deriving the price or option premium are common
across banks.

The different price quotes are largely driven through

differences in the data input such as:
1. Strike price

2. Underlying price

3. Maturity

4. Premium and

5. Each banks own currency liquidity positions.

The price given by APEX has to be adjusted for a slew of factors like volatilities,
skew etc.[add some more details on this]

Pricing of transactions
Protocol for pricing in APEX

1. Choosing of the currency pair from APEX

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 2. APEX automatically generates
- Option cut
- Premium style
- Today
- Spot date
- Premium pay date
- Spot rate
3. By clicking on the arrow next to option type, APEX will show a scroll down
menu with the list of options that can be priced.
4. Having chosen the option type the next steps are:
-filling in the expiry date
-call/put [just c or p has to be typed]
-currency of the notional
- Notional amount
-strike

5. The fields marked in white can be changed changing one of the fields will
change the swap points, the outright forward rate and hence the price.

6. If `?’is typed in the client Vol. it is possible to add a certain level of IRV to
the final price. The system will recalculate the volatility level.

7. Now the client has agreed with the price and is ready to book the trade.

8. The DEAL button has to be clicked.

D. MINDALIGN

An internal system used by treasury for communicating with dealers across

the bank’s centers all over the world.
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 E. REUTERS

REUTERS is a system that the dealers use for checking the currency levels,
interest rate levels which change every second.

F. BLOOMBERG

It is used to download rates. To download rates from Bloomberg, following

has to be clicked on excel’s history wizard:
1. Click next to select pricing
2. Scroll to select
3. Click next to select
4. Click next to specify

G. Nike Predeal checker

It is the internal system used to check the limits for a client. It also gives
exposure and the expected loss for the position that the client has taken. The
dealer should check this before entering into another deal with the client.

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II. METHOD OF DETERMINING PRICES
AS PER THE TRANSACTIONS

Determination of Pricing of an option

The commonly used formula for option pricing is the Black-Scholes model.
In today’s markets, pricing tools are available to arrive at the option price.
SCB uses systems such as Tempest and Apex to price options. These are
based on the Garman Kohlhagen model, which is a modified version of the
Black-Scholes model.

Determination of a cross-rate

Calculation of AUD/INR:

Client wants to sell 1m AUD against INR-

Trader quotes:

AUD/USD 0.9000/0.9004 USD/INR

39.60/39.61

AUD/INR 0.9000*39.60=35.64 1 AUD = 35.64

Explanation :

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 - Client sells AUD/buys USD at 0.9000
- Client sells USD/buys INR at 39.60
- Client sells AUD/buys INR at 35.64

How are swap points determined?

Example:

Today = 18 August 2006

a. Client wants to buy USD 1 million against INR for 29 sep. ‘06
Spot: 39.50/51
Forward for 29 Sep. ’06: 0.14/0.15
Rate = 39.51+0.15= 39.66

How is the forward rate of a currency pair

determined?
Forward premium for a currency pair are derived from interest rate differentials
between the two currencies. Interest rate parity implies that the exchange rate
between the two countries will incorporate the interest rate differential between the
two currencies such that no arbitrage exists.

Example:

Suppose USD/INR on 10th. Feb. = 39.50/.60 the interest rates prevalent are:

US =5.25/5.5

INR = 6.75/6.875

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The month forward rate can be calculated as follows:

- Borrow one month dollars at the spot rate @ 5.5

- Buy INR at the spot rate i.e. 39.50
- Deposit the INR for I month @ 6.75
- At maturity, assuming 1$ was borrowed , the transactions will lead to the
following:
- Principal +interest to be paid = 1+(1*5.5*30)/(100*360) = 1.0046
- Principal + interest earned = 39.50+(39.50*6.75*30)/(100*360) = 39.7222

Therefore, the 1 month forward bid rate = 39.7222/1.0046 = 39.5403

How are forwards quoted in the Indian market?

In the Indian markets, forwards are quoted in paisa terms for month ends. Just as
spot rates, they are also quoted 2 way viz bid and offer. There is no market for
exact maturity dates, which can be extrapolated using month end dates. Forwards
are generally quoted for a period up to one year. There is no market for forward
quotes greater than one year. However, the same can be derived using interest rate
differentials on the specific request of the customer. As per regulations, a forward
contract for greater than one year requires an ISDA agreement to be signed.

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How is the forward premium determined for rupee vs.
dollar?
INR is a partially convertible currency, which implies the interest rate parity does
not fully hold. In spite, interest rate differentials are the key determinants of
forward premium. A summary of factors influencing rupee forwards is:

-Cost of carry: the relationship between forward rates and spot rates can be
summarized in terms of cost of carry. Cost of carry increases due to higher interest
rate differential. For example, if initially the interest rates in India and the US are
5% and 4% respectively, the differential is 1%. Now if the interest rate in India
increases to 5.5%, the differential is 1%. Now if the interest rate in India increases
to 5.5%, the differential will increase to 1.5%making it costlier to hold dollars.
This means that if one wants to sell forward dollars against rupees the forward
premium receivable will increase due to higher cost of holding dollars.

- Type of customers: this will determine if forward premium is paid or received.

Exporters will receive forward premium whereas importers will pay it for
currencies, which sell at a premium i.e. have lower interest rates. If more forward
premium is being received than paid, the forward premium will start to come off.

-Expectation of liquidity: ALM will pay forward premium if liquidity is tight. The
exchange rates are essentially determined by conditions of demand and supply. If
demand for a currency is high, it becomes costlier and if the supply is high it
becomes cheaper.

-Interest rate differential: the currency that has a lower interest rate is traded at a
premium and vice versa. This is again due to the higher cost of carry for having the
currency that pays a lower interest rate. If this were not the case, arbitrage
opportunity would be available.

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 III. CLIENT CLASSIFICATION

Clients are classified into the following categories:

Category I
- The client is listed on a recognized stock exchange or belongs to a group that
is listed
- Is a significant well-established entity, that is, it has at least US $ 10m net
assets and has been established for at least 10 years or
- Has an organized treasury department consisting of 3 or more individuals
and
o Uses a wide range of global market products, uses market terminology
and does not ask for advice and
o Uses sophisticated risk management techniques and has systems to
manage and monitor any risks that it takes or runs.

Category 2
- The client has a treasurer, finance director or other officer that has an
understanding of the fundamentals of GM products and risk management
and is able to understand and make an independent decision on transactions
- Has system to monitor any risks that it runs and
- Uses a range of GM products

Category 3
- Clients not falling within 1 or 2

These procedures are in addition to any local regulatory requirements that call for
clients to be classified.

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Simpler way to identify potential transactions for clients
The transactions are color coded as follows:

- Green : no special approval or clearance required

- Red : must be approved by the RM
- Black : transaction type is not traded at all

Of these customers the big clients are given the inter-bank rates while the rest are
provided with the rates after keeping the margin of the dealers.

Some other important details

Nostro accounts
A banking term to describe an account one bank holds with a bank in a foreign
country, usually in the currency of that foreign country. Nostro is our account of
our money, held by you.

Typical usage of nostro accounts

Nostro accounts are mostly commonly used for currency settlement, where a bank
or other financial institution needs to hold balances in a currency other than its
home accounting unit.

For example: First National Bank of A does some transactions (loans, foreign
exchange, etc.) in B$, but banks in A will only handle payments in A$. So FNB of
A opens a B$ account at foreign bank Credit Mutuel de B, and instructs all
counter-parties to settle transactions in B$ at "account no. 123456 in name of
FNBA, at CMB, X Branch". FNBA maintains its own records of that account, for
reconciliation; this is its nostro account. CMB's record of the same account is the
vostro account.

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Now, FNBA sells A$1,000,000 to C (a counterparty who has an A$ account with
FNBA, and a B$ account with CMB) for a nett consideration of B$2,000,000.
FNBA will make the following entries in its own accounting system.

(Internal) FX A$ trading 1,000,000 1,000,000

A$ Account in name of C
account DR CR

B$ Nostro at CMB (FNBA's 2,000,000 (Internal) FX B$ trading 2,000,000

nostro) DR account CR

Over at CMB, they record the following transaction:

B$ Account in 2,000,000 B$ Account in name of FNBA 2,000,000

name of C DR (CMB's vostro) CR

[This is somewhat simplified; in reality C may not have an account with FNBA's
corresponding bank, and will make settlement by cheque or some form of EFT. In
this case CMB will make entries on several other accounts, such as a Teller's
receiving account, or a clearing account with the third bank that the cheque was
written on.

Vostro account
Local currency account maintained by a local bank for a foreign (correspondent)
bank. For the foreign bank it is a nostro account.

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Non-deliverable forward (NDF)
An outright forward or futures contract in which counterparties settle the
difference between the contracted NDF price or rate and the prevailing spot price
or rate on an agreed notional amount. It is used in various markets such as foreign
exchange and commodities. NDFs are prevalent in some countries where forward
FX trading has been banned by the government (usually as a means to prevent
exchange rate volatility).

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