AFM Module A:6. Foreign Exchange Arithmetic

6. Foreign Exchange Arithmetic


1.   Foreign Exchange: Conversion of currencies from the currency of invoice to the home currency of the exporters is called as Foreign Exchange.

2.    Foreign Exchange Management Act (FEMA),1999 defines Foreign Exchange as o “ All deposits, credits and balances payable in foreign currency and any drafts, traveler’s Cheques, LC and Bills of Exchange, expressed or drawn in Indian Currency and payable in any foreign currency.”

               Any instrument payable at the option of the drawee or holder, thereof or any other party thereto, either in Indian Currency or in foreign currency, or partly in one and partly in the other.

3.    A Foreign Exchange transaction is a contract to exchange funds in one currency for funds in another currency at an agreed rate and arranged basis.

4.   Exchange Rate means the price or the ratio or the value at which one currency is exchanged for another currency.

5.   Foreign Exchange markets participants are C³I²F¹

#  Central Banks

#  Commercial Banks

#  Corporations

#  Individuals

#  Investment Funds/Banks

#  Forex Brokers

6.  The Forex Markets are highly dynamic, that on an average the exchange rates of major currencies fluctuate every 4 Seconds, which effectively means it registers 21,600 changes in a day (15X60X24)

7.  Forex markets usually operate from “Monday to Friday” globally, except for the Middle East or other Islamic Countries which function on Saturday and Sunday with restrictions, to cater to the local needs, but are closed on Friday.

8.  The bulk of the Forex markets are OTC (Over the Counter).

9.  Factors Determining Exchange Rates:

a)  Fundamental Reasons

BE an MP IF possible

# Balance of Payment

# Economic Growth rate

# Fiscal policy

# Monetary Policy

# Interest Rates

# Political Issues

b)  Technical Reasons

-  Government Control can lead to unrealistic value.

-  Free flow of Capital from lower interest rate to higher interest rates

c) Speculative - higher the speculation higher the volatility in rates

10.   Due to vastness of the market, operating in different time zones, most of the Forex deals in general are done on SPOT basis.

11.   The delivery of FX deals can be settled in one or more of the following ways:

#  Ready or Cash

#  TOM

#  Spot

#  Forward

#  Spot and Forward

12.   Ready or Cash: Settlement of funds takes place on the same day (date of Deal).

13.   TOM: Settlement of funds takes place on the next working day of the deal. If the settlement day Is holiday in any of the 2 countries, the settlement date will be next working day in both the countries.

14.    Spot: Settlement of funds takes place on the second working day after/following the date of Contract/deal. If the settlement day is holiday in any of the 2 countries, the settlement date will be next working day in both the countries.

15.   Forward: Delivery of funds takes place on any day after SPOT date.

16.   Spot and Forward Rates: On the other hand, when the delivery of the currencies is to take place at a date beyond the Spot date, it is Forward Transaction and rate applied is called Forward RateForward Rates are derived from Spot Rates and are function of the spot rates and forward premium or discount of the currency, being quoted.

17.   Forward Rate = Spot Rte + Premium or – Discount

18.   If the value of the currency is more than being quoted for Spot, then it is said to be at a premium.

19.   If the currency is cheaper at a later date than Spot, then it is called at a Discount.

20.   The forward premium and discount are generally based on the interest rate differentials of the two currencies involved.

21.   In a perfect market, with no restriction on finance and trade, the interest factor is the basic factor in arriving at the forward rate.

22.   The Forward price of a currency against another can be worked out with the following factors:

#  Spot price of the currencies involved

#  The Interest rate differentials for the currencies.

#  The term i.e. the future period for which the price is worked out.

24.   The price of currency can be expressed in two ways i.e. Direct Quote, Indirect Quote.

25.   Under Direct Quote, the local currency is variable E.g.: 1 USD = `48.10

26.   Direct Quote rates are also called Home Currency or Price Quotations.

27.    Under indirect Quote, the local currency remains fixed, while the number of units of foreign currency varies. E.g. `100 = 2.05 USD

28.    Globally all currencies (Except a few) are quoted as Direct Quotes, in terms of USD = So many units of another currency)

29.    Only in case of GBP (Great Britain Pound) £, €, AU$ and NZ$, the currencies are quoted as indirect rates.

30.   Japanese Yen being quoted per 100 Units. Cross Currency Rates: When dealing in a market where rates for a particular currency pair are not directly available, the price for the said currency pair is then obtained indirectly with the help of Cross rate mechanism.

31.   How to calculate Cross Rate?:

The math is simple algebra: [a/b] x [b/c] = a/c

Substitute currency pairs for the fractions shown above, and you get, for instance, GBP/AUD x AUD/JPY = GBP/JPY.

This is the implied (or theoretical) value of the GBP/JPY, based on the value of the other two pairs. The actual value of the GBP/JPY will vary around this implied value,as the following calculation shows.

Here are Friday's actual closing BID prices for the 3 currency pairs in this example (taken from FXCM's Trading Station platform): GBP/AUD = 1.73449, AUD/JPY = 0.85535 and GBP/JPY = 1.48417.

Now, let's do the math: GBP/AUD x AUD/JPY = GBP/JPY

1.73449 x 0.85535 = 1.4836, which is not exactly the same as the actual market price

Here's why. During market hours (Sunday afternoon to Friday afternoon, EST), all prices are LIVE, and small departures from the mathematical relationships can exist momentarily.

33. Fixed Vs Floating Rates:

#  The fixed exchange rate is the official rate set by the monetary authorities for one or more currencies. It is usually pegged to one or more currencies.

#  Under floating exchange rate, the value of the currency is decided by supply and demand factors for a particular currency.

34.   Since 1973, the world economies have adopted floating exchange rate system.

35.   India switched to a floating exchange rate regime in 1993.

36.   Bid & Offered Rates: The buying rates and selling rates are referred to as Bid & Offered rate.

37.   Exchange Arithmetic – Theoretical Overview:

#   Chain Rule: It is used in attaining a comparison or ratio between two quantities linked together through another or other quantities and consists of a series of equations.

#  Per Cent or Per mille: A percentage (%) is a proportion per hundred. Per Mille means per thousand.

38. Value Date: The date on which a payment of funds or an entry to an account becomes actually effective and/or subjected to interest, if any. In the case of TT, the value date is usually the same in both centers.

39.    The payments made in same day, so that no gain or loss of interest accrues to either party is called as Valuer Compense, or simply here and there.

40.   Arbitrage in Exchange: Arbitrage consist in the simultaneous buying and selling of a commodity in two or more markets to take advantage of temporary discrepancies in prices.

41.   A transaction conducted between two centers only is known as simple or direct arbitrage.

42.   Where additional centers are involved, the operation is known as compound or Three (or more) point arbitrage.

43.   Forex Operations are divided into 3:

1)   Forex Dealer

2)   Back Office

3)   Mid Office

44. The Forex dealing room operation functions:

#   a service branch to meet the requirement of customers of other branches/divisions to buy or sell foreign currency,

#  Manage foreign currency assets and liabilities,

#  Fund and manger Nostro Accounts as also undertake proprietary trading in currencies.

#  It is a separate profit center for the Bank/FI

45.   A Forex Dealer has to maintain two positions – Funds position and Currency Position

46.   Funds position reflects the inflow and out flow of funds.

47.   Back office takes care of processing of Deals, Account, reconciliation etc. It has both a supportive as well as a checking role over the dealers.

48.     Mid Office deals with risk management and parameterization of risks for forex dealing operations. Mid Office is also supposed to look after the compliance of various guidelines/instructions and is an independent function.

49.   The major risks associated with the dealing operations are :

#  Operational Risk

#  Exchange Risk

#  Credit Risk

#  Settlement Risk

#  Liquidity Risk

#  Gap Risk/ Interest/ Rate Risk

#  Market Risk

#  Legal Risk

#  Systemic Risk

#  Country Risk

#  Sovereign Risk

50.     The Operation Risk is arising on account of human errors, technical faults, infrastructure breakdown, faulty systems and procedures or lack of internal controls.

51.   The Exchange Risk is the most common and obvious risk in foreign exchange dealing operations and arise mainly on account of fluctuations in exchange rates and/ or when mismatches occur in assets/ liabilities and receivables/ payables.

52.    Credit risk arises due to inability or unwillingness of the counterpart to meet the obligations at maturity of the underlying transactions.

53.   Credit Risk is classified into

#  Pre- Settlement Risk

#  Settlement Risk

54.    Pre Settlement Risk is the risk of failure of the counter party before maturity of the contract thereby exposing the other party to cover the transaction at the ongoing market rates.

55.   Settlement Risk is Failure of the counter party during the course of settlement, due to the time zone differences, between the two currencies to be exchanged.

56.   Liquidity Risk is the potential for liabilities to drain from the bank at a faster rate than assets. The mismatches in the maturity patterns of assets and liabilities give rise to liquidity risk.

57.    Gap Risk/ Interest Rate Risk are the risk arising out of adverse movements in implied interest rates or actual interest rate differentials.

58.    Market Risk: This is arises out of adverse movement of market variables when the players are unable to exit the positions quickly.

59.   Legal Risk is arising on account of non-enforceability of contract against a counter party.

60.   Systemic Risk is the possibility of a major bank failing and the resultant losses to counter parties reverberating into a banking crisis.

61.   Country Risk is risk of counter party situated in a different country unable to perform its part of the contractual obligations despite its willingness to do so due to local government regularizations or political or economic instability in that country.

62.   Sovereign Risk is over all country risk

63.   RBI has prescribed guidelines for authorized dealers, permitted by it, to deal in foreign exchange and handle foreign currency transactions.

64.   FEMA 1999 also prescribes rules for persons, corporate etc in handing foreign currencies, as also transactions denominated therein.

65.    The RBI is issued licenses to Authorized Dealers to undertake foreign exchange transactions in India.

66.     The RBI has also issued Money Changer License to a large number of established firms, companies, hotels, shops etc. to deal in foreign currency notes, coins and TCs

67.   Full Fledged Money Changers (FFMC) : Entities authorized to buy and sell foreign currency notes, coins and TCs

68.   Restricted Money Changers (RMCs): Entities authorized to buy foreign currency.

69.    Categories of Authorized Dealers; in the year 2005, the categorization of dealers authorized to deal in foreign exchange has been changed.

Category                            Entities

AD - Category I                 Banks, FIs and other entities allowed to handle all types of Forex

AD - Category II                Money Changers (FFMCs)

AD - Category III               Money Changers (RMCs)

70.   Foreign Exchange Dealers Association of India, FEDAI (ESTD 1958) prescribes guidelines and rules of the game for market operations, merchant rates, quotations, delivery dates, holiday, interest on defaults , Handling of export – Import Bills, Transit period, crystallization of Bills and other related issues.

71.    Export bills drawn in foreign currency, purchased/ Discounted/ negotiated, must be crystallized into rupee liability. The same would be done at TT selling rate.

72.   The crystallization period can vary from Bank to bank, (For Export Bills Generally on the 30th Day) customers to customer but cannot exceed 60 days.

73.   Sight Bills drawn under ILC would be crystallized on the 10th day after the due date of receipt if not yet paid.

74.   All forward contracts must be for a definite amount with specified delivery dates.

75.   All contracts, which have matured and have not been picked up, shall be automatically cancelled on the 7th working day, after the maturity date.

76.   All cancellations shall be at Bank’s opposite TT rates. TT Selling = purchase contracts; TT buying =

Sale contracts.

77.   All currencies to be quoted per unit Foreign Currency = `, JPY, Indonesian Rupiah, Kenyan Schilling quoted as 100 Units of Foreign currency = `.

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