By

Rajeev Kumar Jha

Treasury Department
Chinatrust Commercial Bank Ltd.,
New Delhi Branch

There is no sphere of human

influence in which it is easier to
show superficial cleverness and
the appearance of superior
wisdom as in matters of
currency and exchange
Winston Churchill
House of Commons 1946

Basic
Concepts,
Terminologies,
Instruments & Mechanism.
Exchange Rate Regimes
Historical perspective
Foreign Exchange Trading & rate
quotations
Role of Reserve Bank of India (RBI)
in the FX Market.

BASIC
CONCEPTS/TERMINOLOGI
ES

As per
Foreign
Exchange
Act,
Foreign
Currency
vs. Foreign
(Section 2),Exchange
1947.
(c) "Foreign

Currency" means
any currency other than Indian
currency;
(d)"Foreign

Exchange" means
includes any instrument drawn,
accepted, made or issued under
clause (8) of section 17 of the
Banking Regulation Act, 1956, all
deposits, credits and balance
payable in any foreign currency,
and any drafts, travelers cheques,
letters of credit and bills of
exchange, expressed or drawn in
Indian currency but payable in any
foreign currency;

Financial market is a place

where Resources/funds are
transferred
from
those
having
surplus/excess
to
those
having
a
deficit/shortage.

The market where the

commodity traded is Currencies.
Price of each currency is
determined in term of other
currencies.

What is an Exchange Ra
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.

All Scheduled Commercial

Banks
(Authorized Dealers only).
Reserve Bank of India (RBI).
Corporate Treasuries.
Public Sector/Government.
Inter Bank Brokerage Houses.
Resident Indians
Non Residents
Exchange Companies
Money Changers

FOREIGN EXCHANGE
REGIMES
FIXED
PEGGED
COMPOSITE
MANAGED FLOAT

FREE FLOATING

Components of a
Standard
FX Transaction

Base Currency (USD/INR)

Dealt or Variable Currency
Exchange Rate
Amount
Deal Date
Value Date

Settlement
Instructions

Currencies are traded both

in Ready and forward value
dates.
1) Ready: Settlement on the deal
date. e.g. India
2) Value Tom : Settlement on next
day. e.g. Canada
3) Spot Transaction : Settlement
usually in two working days.
In International FX transactions,
Spot is the Standard value date.
Why Spot Date ?

Time Zone Difference

Herstat Risk

4) Forward Transaction:
Settlement at some future date
ahead of the spot.
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FX Rate Quotation:
In the forex market rates are always
quoted two way.
Two way quote gives both Bid and
Offer.
e.g.
USD/INR= 48.50 / 60
Bid / Offer
Big Figure:

Term referring to the first digits of an exchange

rate. These figures are rarely change in normal market
fluctuations and are usually omitted in dealer quotes.

Pips (or Point):

The smallest incremental move an

exchange rate can make.

Base Currency Vs. Dealt Currency

Number of variable or dealt currency unit in
one unit of base currency.
In international quotes base currency comes
first.
e.g. BC/VC
USD/INR= 48.50/60

Price maker Vs. Price Taker

The bank quoting the price is
price maker or market maker.
The bank asking for the price or
quote is the price taker or
user.

IN-DIRECT QUOTATION:

Price of one Unit of Foreign

Currency in terms of
Domestic Currency
e.g. USD/INR = 48.50/60
Buy One USD at
Sell One USD at
Spread

48.50
48.60
00.10

In the international market,

almost all currencies are
quoted indirectly.

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DIRECT QUOTATION:
Price of one Unit of Domestic Currency
in terms of Foreign Currency
e.g. EURO= 1.2805/12
Buy One Euro at
Sell One Euro at
Spread

1.2805
1.2812
0.0007

Five Currencies are quoted in Direct

Terms
1)
2)
3)
4)
5)

Pound Sterling
Euro
Australian Dollar
New Zealand Dollar
Irish Punt

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In the international
market, almost all the
currencies are quoted in
terms of USD.
e.g.
JPY= 105.78/82

A visit to REUTERS EFX= Page.

FORWARD TRANSACTIONS
1.

Out right sale/purchase of a

currency against the other for
settlement at a future date at
the predetermined exchange
rate.

2.

Forward rates are quoted as

premium or discount over spot
rate.

3.

Forward rates depend upon

interest rate differential
between the two currencies.

4.

Currency with higher interest

rates is at discount wrt currency
having lower interest rate.

5.

Currency with lower interest

rates is at premium wrt
currency having higher interest
rate.

Calculating Forward Rate

Interest rate of USD
1.25%
Interest rate of INR
6.00%
Spot Rate
48.50
DB for INR
Actual/365
DB for USD
=
Actual/360

=
=
=
=

Six month Forward Rate =

spot rate (48.50) x (1+ .
06*181/365)/(1+.0125*181/360)
=59.87

FX SWAP Transaction
An FX swap is a contract to buy
an amount of currency for one
value date at an agreed rate, and
to simultaneously resell the same
amount of currency for a later
value date, also at an agreed rate,
to the same counter party.
FX swap is essentially a funding
or Money Market transaction and
does not involve exchange risk.

 Foreign exchange transactions are

settled through Nostro and Vostro
accounts.
Nostro: our account with banks abroad.
Reserve Bank of India (RBI) maintains
various Nostro accounts in a number of
countries.
Vostro: their account with us. Many
multilateral agencies (e.g. IMF, World
Bank) maintain their Nostro accounts at
Reserve Bank of India (RBI).

SWIFT (Society for Worldwide Interbank

Financial Telecommunications)

Deals are done over

Telephone, REUTERS
dealing system etc
REUTERS

Dealing Terminal

Industry Standard for FX trading.

Security guaranteed by Reuters
Int.
Password Protected.
Maintains record of all
transactions.

News Terminal

Domestic Market Data/ news

available on line.
Real Time Exchange Rate quotes
of all major Currencies.
Data about Interest Rates (e.g.
LIBOR)
Various Reserve Bank of India
(RBI) pages on REUTERS.

Pre-Reform era till early 90s

( The fixed ERM & Exchange
Control Regime)
Fixed ERM, with occasional devaluations.
Reserve Bank of India (RBI) to fix its buying
& selling rates for Authorized Dealers and their rates
for customers.
Residents not allowed to hold foreign exchange.
Only ADs (Banks), allowed to deal in Fx.
Fx available only for current account transactions.
(goods & services) and some other personal
transactions viz. travel, education, medical treatment
etc.

Pre-Reform era till early 90s

(The fixed ERM & Exchange Control
Regime)

Reserve Bank of India (RBI) to buy and sell

forex from and to ADs, at its buying and
selling rates for Authorized Dealers.
Reserve Bank of India (RBI) to provide
forward cover to ADs for importers and
exporters as well as foreign currency loans
mobilized by corporates from abroad.
Exporters of goods and services, were
bound to sell forex to an AD at rates
prescribed by Reserve Bank of India (RBI).
Elaborate system of reporting by ADs to
Reserve Bank of India (RBI).

Market liberalization. The

decade of 90s
Early nineties marked an era of liberalization of
foreign exchange market.
FCAs Scheme was launched for Resident
Pakistanis. Banks were required to surrender their
FC deposits against purchase of forward cover
from Reserve Bank of India (RBI).
Money Changers were authorized to Deal in
foreign exchange (Notes and TCs only).
Forward cover for imports and exports shifted to
banks.
Forward cover for FC loans also transferred to
banks (under certain rules and regulations).

Post detonation crisis (May

98) and move towards
market based ERM.

In early 98, India was making

gradual moves towards market
based ERM.
Third currency rates to be quoted
by banks.
Reserve Bank of India (RBI) also
stopped giving customers buying
and selling rate and gave a 1%
band to the market, quoting its
buying and selling rates for ADs.
The target was to put the currency
on free float.

Post detonation crisis (May

98) and move towards
market based ERM.

Detonation of May 98 changed the way things

were moving.
Despite low reserves, Reserve Bank of India (RBI)
made the decision of going ahead with fx market
reforms.
Phased approach was adopted for transition to
free float.
As a first step Two-Tier ERM was introduced in
July 21, 1998.
Except for essential items (e.g. wheat l/cs) , the
rest of the trade transactions were settled through
interbank market.
Initially 50/50 , 80/20, FINALLY 95/05

Post detonation crisis

(May 98) and move
towards market
based ERM.
Two-tier was finally abolished in May
1999.
Currency was freely floated.
Regulations pertaining to current
account transactions remained more
or less unchanged. However all
transactions were to be done at
interbank rate and every bank was to
offer its own rate to customers.
However, an unofficial narrow band
was imposed on banks, which
remained there till July 2000. when it
was finally done away with.

Forex Transactions
The Demand Side of inter-bank
market
importers buying foreign
exchange to finance their imports.
A host of regulations governing
imports into India.
Out ward remittances for debt
servicing.
Out ward remittances for services.
PTEQ and BTQ, Medical treatment
etc.

Forex Transactions
The Demand Side of inter-bank
market
Remittances on account of
education abroad.
Remittances on account medical
treatment.
Repatriation of profit of foreign
controlled companies and freight
collection etc.
Disinvestment through SCRA.
A host of other invisible payments.

Forex Transactions
The Supply Side of inter-bank
market
Exports regulations governing
export receipts.
Home remittances.
Foreign Direct Investment.
Capital account receipts.
Investment through SCRA.
A host of other invisible receipts.

Foreign Exchange
Risk
Exposure to exchange rate
movement.
1. Any sale or purchase of
foreign currency entails
foreign exchange risk.
2. Foreign exchange
transaction affects the net
asset or net liability
position of the
buyer/seller.
3. Carrying net assets or net
liability position in any
currency gives rise to
exchange risk.

NET OPEN POSITION- (NOP)

A measure of foreign
exchange risk
NOP is the Net Asset/Net
Liability position in all FCs
together (Both B/S & Off B/S).
Net Asset Position is also
called LONG or
Overbought position.
Net liability Position is also
called SHORT or Oversold
position.
NOP is a single statistic that
provides a fairly good idea
about exchange risk assumed
by the bank.
Its major flaw is that FX
exposures in third currencies

EXAMPLE (NOP)
(USD in Mio)
Opening Position
$ 0.00
Ready Purchases from Exporter
$ 1.00
Fwd Purchases from Corporate (1.00
Euro) \
$ 0.90
Ready Sell to importer ( 60 Mio Yen)
- $ 0.50
Fwd Sell to Corporate
- $ 0.40
NET OPEN POSITION
$ 1.00

Introduction to Inter-bank FX ac
Foreign Exchange Exposure
FX Exposure is the higher of the long
and short positions in FCs.

EXAMPLE
Currency-wise NOP in equivalent INR
CURRENCY

Dollar

SHORT

LONG

-10

Yen
Euro
-10
Pound
Total
-20
Net Open Position is 0 while
exposure is 20.

10
10
20

Foreign Exchange
Markets
Role of Reserve
Bank of India (RBI)
and linkages with
economy

To manage the exchange rate

mechanism.

Regulate inter-bank forex

transactions and monitor the
foreign exchange risk of the banks.

Keep the exchange rate stable.

Manage and maintain country's
foreign exchange reserves.

RBIs Role in the Forex

Market
RBI has imposed foreign
exchange exposure limits
on banks (FE 12 of 1999).
The limits are tied with the
Paid up capital of the bank.
Previously banks had NOP
limit, which was based on
foreign exchange volume
handled by the bank.

TREASURY OPERATIONS AT RBI

1.

2.
3.

4.

5.

All
Central
Banks
have
treasuries to implement policy
objectives vis a vis EXCHANGE
RATE & INTEREST RATES
Dealing room catered to the FX
market only
Money market was being
looked after by the Securities
department
It soon became apparent that
the two cannot work in
isolation with each other as the
linkage between the money
market & exchange market
became pronounced
Finally the dealing room and
securities department were
merged to form EDMD to from
first ever Treasury of RBI.

Functions of DMMD

Market Monitoring
Pro

active monitoring of
interbank MM & FX market by
Front Office.
Prepare demand/supply
forecast.
Gather data from various
Sources.
Real time feedback to
management.
Real time remedial measures to
remove distortions in the
market.

A day in the Front

Office
NOP

report.
FX inflow/outflow statements.
Oil payments,
Forward transactions.
Market monitoring Market
Flows and their impact on
exchange rate.
Money Market liquidity
Forward rates
Market activity if required
Rates Preparation M2M, Wtd.
Avg, FCA Conversion.

Front Office
Challenges

Small Market Size

Lumpy payments
Leads and Lags.
Historical trend of keeping long
positions.
The issue of entries in transit.

INTERVENTION
To

keep exchange rate in

line with macro objectives
RBI has to intervene from
time to time
Intervention is a process
where FX is sold or
purchased to keep the
right amount of liquidity
available in the FX market
so that demand / supply
equilibrium is maintained
Intervention can be in
READY or FORWARD

OTHER FX RELATED
FUNCTIONS
OFFSITE MONITORING
DAILY RATES FOR MARKET
THIRD CURRENCY ACTIVITY FOR
GoP PAYMENTS
RESERVE MANAGEMENT

Off Site monitoring of

banks by RBI
Inputs of
Computerized
Reporting
System (CRS)

All individual foreign exchange

transactions reported by each
bank on daily basis on a floppy
diskette
Amount Currency Posting date

Counter Party
Rate

Deal Date

Type of Deal
Maturity Date
Mode of Dea

Off Site monitoring

of banks by RBI
Reports
from CRS

Exposure Report
FE - 25 balances & other depos
Nostro Balances
Un-reconciled interbank deals

Off Site monitoring of

banks by RBI
Reports from CRS

Contd

Reports for research & statistica

Types of transactions/customer

Business volume - banks/custo

Broker wise market volume rep

History of exchange rates - tre

How does RBI

manages exchange
rate in the
interbank market?
Non-Quantitative
Tools
Quantitative Tools

Non-Quantitative
Tools

Moral suasion
facilitating large
commercial outflows
Relaxation in FEEL

How does RBI

manages exchange
rate in the
interbank
market?
Quantitative
Measures
Foreign Exchange Exposure Limit
(FEEL)
Basically restricts the banks to
keep a net asset (long) or net
liability (short) position in foreign
currencies.
Presently FEEL for each bank is set
at 10 % of its paid up capital.
In the presence of FEEL, banks net
purchases or net sales in foreign
exchange on a given day have to
be within their FEEL.

Physical
intervention
Direct selling or buying of
foreign exchange by State Bank
in the interbank market.
Such sale/purchase can be in
spot or forward value
It can have two objectives
To provide support to the
market for
lumpy payments
To manage the Rs/$ parity
Intervention may be direct or
indirect. Currently RBI only
indirectly intervenes in the
market.

RESERVE BUILDING

Thank You

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