Exchange Rates and Forex Business
Introduction :
Cross-border movement of commodities, services, man power and capital is one of the biggest drivers of the economic activity. This module focuses on understanding the role of banking in this particular area. which is also known as international banking. Exchange rates and the business of dealing in foreign exchange are two important aspects of international banking.
in this unit, you learn about:
- The definition and meaning offoreign exchange
- The mechanism of the foreign exchange (forex) market
- The factors affecting forex rates
- The guidelines relating to forex
- The factors related to dealing in forex
Foreign Exchange Markets :
A Foreign Exchange (forex or FX) transaction is primarily defined as the exchange of one currency (or currency equivalent like traveller cheques and drafts) for another currency by two parties at an agreed price. The ratio at which the Currencies are exchanged is called the exchange rate.
Example
One US Dollar (USD) can be exchanged for approximately 44.8 lndian Rupees (lNR) as of June 2011. Hence, the exchange rate is denoted as 1USD = 44.8 INR. Similarly, 1 EUR = 1.4364 USD.
Forex Participants :
There are various participants that trade foreign currencies.
Foreign Exchange Management Act :
The Foreign Exchange Management Act (FEMA) is the primary act controlling the activities related to foreign exchange. The Reserve Bank of India (RBI) is responsible for implementing the controls and managing the currency. The forex market is one of the largest markets in existence as various currency pairs are traded around the world. Places like Tokyo, Singapore, Hong Kong, London and New York have been established as the centres of FX trade.
Some characteristics of the forex market are:
- It is practically a twenty four hour market.
- It is a liquid market with many bids and ask offers.
- FX trades happen across the world, but trade in individual currency pairs may be restricted to certain countries because of lack of interest or regulations.
- Markets are affected by Government policies and regulations.
Exchange Rate Market Mechanism :
Certain concepts help in understanding the mechanism of exchange rate markets. It is important to understand these conventions to arrive at the right price.
Delivery Time :
As FX trade is generally conducted across different time zones, the settlement time is an important factor in determining a contract. There are various ways in which the delivery of FX can be settled.
Spot Basis :
This is when the currencies are delivered on the second working day following the day of the deal/contract. The exchange rate used for this purpose is called the spot exchange rate.
Example :
If the date of the deal is on March 6, 2017 (Monday), the settlement date will be on March 8, 2017(Wednesday, provided all the markets involved are working on the March 6, 7 & 8).
Ready/Cash Basis :
This is when the settlemeht takes place on the same day of the deal.
Example :
If the date of the deal is on March 6, 2017 (Monday), the settlement date will also be on March 6, 2017 (Monday).
Tom Basis :
This is when the settlement takes place the day after the deal is made.
Example :
If the date of the deal is on March 6, 2017 (Monday), the settlement date will be on March 7, 2017 (Tuesday, provided it is a working day for all the markets involved). If it so happens that Tuesday is a holiday in either of the two countries, then the settlement date will be the next working day in both the countries involved.
Forward Basis :
This is when settlement takes place on a future date determined on the day the deal is made. The exchange rate used for this purpose is called forward rate.
Example :
If the day of the forward deal is March 6, 2017 (Monday), for settlement date March 22, 2017, it is termed as a forward deal.Spot and Forward Rates While the spot rate is the popularly used rate in the exchange rate market, forward settlement is also often used depending on the needs of both the parties. On any given day there would be several forward rates depending on the future date of settlement. Usually, forward rates are derived from spot rates and are a function of the spot rates and forward premium or discount of the currency being quoted.
Thus, Forward Rate = Spot Rate + Premium (Or — Discount)
The primary determinants of the premium or discount are the time for settlement and the interest rate differential between the two currencies. Hence, the longer the settlement period, the higher the premium or discount. If a domestic currency's interest rate is higher than a foreign currency's interest rate, then the foreign currency would be trading at a premium in the forward rate. This implies that the higher the interest rates in a domestic currency relative to the foreign currency, the higher the forward premium for the foreign currency. The relationship between forward rate and interest rates can be expressed as:
1 +t .r dom
FXfwd = FXspot . -------------
1 +t .r for
Where " t " is time for settlement and " rdom " and " rfor " are domestic and foreign interest rates.
Usually the forward rate is quoted as a premium or a discount to the spot rate of the foreign exchange.The premium or discount can be easily calculated from the market forward rate and market spot rate.
For example:
Scenario 1: USD is trading at a bid of INR 45.4 and an offer of INR 45.6 in the spot market. The mid-rate is INR 45.5. The three month forward USD is trading at a bid of INR 45.95 and an offer of 46.05. The mid—forward rate is INR 46. The forward premium is Rs. 0.5 (46 - 45.5) for three months. This situation happens when interest rates in India are more than interest rates in the US.
Scenario 2: USD is trading at bid of INR 45.2 and an offer of INR 45.3 in the spot market. The mid- rate is INR 45.25. The three month forward USD is trading at a bid of INR 44.95 and an offer of 45.05. The mid-forward rate is INR 45. The fonward discount is Rs. 0.25 (45 - 45.25) for three months.This situation happens when interest rates in India are more than intrest rates in the U.S
Direct and Indirect Quotes
In any country, the exchange market usually quotes its local currency against the US dollar (USD) as well as against other foreign currencies. The direct quotation sets the amount of the local currency required to purchase one unit of the foreign currency as well as the amount of the local currency received when you sell one unit of the foreign currency.
FX in India is quoted as 44.8 USD/INR, (based on rates ofJuly 2011), meaning the dollar is bought/sold for 44.8 INR.
On the other hand, an indirect quote gives the amount of foreign currency required to be exchanged for one unit of the domestic currency. This kind of quote is used when trading the British Pound Sterling (GBP) and Euro (EUR) against the US dollar.
In an indirect quote, the FX rate for INR can be written as 0.0223 INR/USD, meaning one rupee can be bought/sold for 0.0223 US dollars.
Bid and Offered Rates :
Exchange rates, just like other financial quotes, have both bid and offer rates.Bid rate is the rate at which a buyer is willing to buy USD (or any foreign currency in direct quote).Offer rate is the rate at which a seller is willing to sell USD (or any foreign currency).
Example :
When someone says the FX market is at 44.6-45 that means that one dollar can be sold for 44.6 INR (bid rate) and one dollar can be bought for 45 INR (offered rate). The difference between the bid rate and offered rate is called the bid/offer spread and it indicates the liquidity of the market. If the market is highly liquid, the bid/offer spread will be really low.
Cross Rates and Exchange Rate Arithmetic :
Not all currency pairs can be traded in each country, but the exchange rate for certain currency pairs can be derived from the others.
If USD/INR rate is 44.8 and EUR/USD rate is at 1.4364, the EUR/INR rate will be at
44.8 *1.4364 = 64.35 EUR/INR.
This logic can be extended to any currency pair to get the exchange rates for which there is no outright market. While doing so one should be careful to note if the FX rate is quoted by the direct or indirect mechanism.
USD/INR = 44.8 and USD/JPY = 80.22 from this JPY/INR = 0.55 Arbitrage in Exchange Rate
Arbitrage is a financial transaction that involves the purchase of securities (foreign currency, gold, commodities) in one market, for immediate resale on another market, while making a profit without involving any risk.
Formula for Arbitrage in Exchange Rate :
Using the earlier formula, some smart traders are able to look at arbitrage opportunities.
Example :
We calculate the exchange rate for Yen and Rupee as JPY/INR = 0.55
If there is a market for JPY/INR currency pair and it is trading at 0.5, then there is an arbitrage opportunity.To lock in these profits the trader would convert Rupees into USD, then USD into Yen and then finally convert Yen into Rupee.If the investor starts with one rupee, he gets 0.02232 USD, which is equivalent to 0.55 JPY. This when converted back to rupees would be INR 1.1. Thus one rupee invested would give back 1.1 rupees instantly without risks.
However, arbitrage profits decrease and can become zero because of bid/offer spreads in the currencies being traded.
CROSS RATES :
Cross rates are actually affected by bid or offer spreads. The right quotes should be taken to
accurately calculate the bid or offer spread. Instead of taking a single rate, the bid or offer on USD/INR is 4475/4485. This means that one USD can be bought for Rs. 44.85 and one USD can be sold for Rs. 44.75. Similarly if the bid offer on USD/JPY is 80.2/80.24, then one USD can be sold for 80.2 JPY and one USD can be bought for 80.4 Y. From this if the value of selling one JPY and converting it into 1 Rupee is calculated, it would be 1 JPY = 1/80.24 USD =44.85/80.2 INR = 05592 INR. SO the bid offer rate for JPY/INR would be 05577105592.
Factors Determining FX Rates :
There are numerous factors responsible for determining the FX rates. A few of them have been detailed below.
Fixed Versus Floating Rate :
There are two ways the central bank of a country manages its FX rates.
- Fixed Exchange Rate:
Countries where the central bank tries to maintain a constant exchange rate with respect to another currency are said to be adopting a fixed rate regime. For example, the Chinese central bank pegs Yuan to US Dollar at a fixed rate. The fixed rate regime is primarily used to maintain stability, especially for exporters and importers. However, a fixed rate regime can create huge capital account imbalances, thus causing long term instability.
Floating Exchange Rate:
. Countries or economies where the value of currency is free to float based on market dynamics are said to have a floating rate regime. Examples of countries employing this
format include UK, Euro Zone and the United States.The floating rate regime helps in identifying costs of labour and goods. This makes it friendlier towards competitive
players. Some countries like India allow the currency to float, but only within a broad range.
Sometimes a mix of both these factors can also be used.
The currency management mechanism is the most important feature that should be looked at when understanding the factors affecting a currency.
FUNDAMENTAL FACTORS:
The fundamental factors that influence the movement of exchange rates are macro-economic in nature. A few have been detailed below.
- Balance of payments:
Trade surpluses usually strengthen the currency versus foreign currency as a high trade surplus would mean more demand for the currency.
Growth rate:
A high growth rate in the economy would be positive for the currency as more money would flow into the country either through trade or through investments.
Fiscal policy:
The fiscal policy affects the growth rate in the economy and through that the currency, thus having an indirect effect on exchange rates.
Political scenarios:
Political uncertainty can lead to an exodus of capital and a drop in trade and is thus negative
to the currency.
Monetary policy and interest rates:
As long as they do not hamper the growth, high interest rates lead to a greater inflow from foreign investors thereby strengthening the currency.
Technical Factors :
A few of the technical factors influencing exchange rates have been detailed below.
- Risk aversion leads to investors withdrawing money from supposedly risky economies.
- Selling off assets leads to outflow of foreign funds. In fact, there is a strong relationship between equities
- Speculation by various entities can also affect exchange rates.
FX Dealing:
For a bank, forex dealing consists of managing foreign currency assets and liabilities, managing cash flows in various currencies and providing liquidity (quotes) to clients for forex transactions. Forex dealers also actively involve themselves in the forex market trading with various counterparties, either to hedge their risks or to provide liquidity to the market.Forex dealing is a highly specialised job involving instant decision making and continuous tracking of the markets.
The various functions of forex dealing are usually split into:
- Front office — Where the dealer actually provides quotes and closes deals
- Back office — responsible for settlement and accounting
- Mid office — responsible for risk management and regulatory compliance
FX Regulations :
Forex trading undertaken across borders without controls not only exposes the party undertaking these transactions to risks but also creates systemic risk for the country. Thus, it is necessary to procure a licence from the RBI when participating in forex trade. RBI has issued 'Authorised Dealer' (AD) licences to all-India financial institutions. These include PSU banks, foreign and large private banks and a few all-India Non-Banking Financial Companies (NBFCs). Also, RBI has issued Money Changer licenses to a large number of established companies to facilitate currency transfer for tourism purposes.
Apart from RBI, the Foreign Exchange Dealers Association of India (FEDAI) also provides certain guidelines for the operation of forex intermediaries.
Some of these guidelines have been detailed below.
RBI/FEDAI Guidlines :
- Forward contracts can be entered only for an underlying exposure.
- The export bill drawn in foreign currency needs to be crystallised into rupee assets in case of delay in realisation. The crystallisation covers import transactions too.
- All forward contracts should be of a definite amount and the date should be clearly specified.
- The option period can be specified by the customer but the delivery period cannot exceed
a month.
- All currencies should be quoted as per unit of foreign currency, while JPY, Indonesian Rupiah and Kenyan Shilling are to be quoted as 100 units of foreign currency.
- FEDAI guidelines allow the banks to structure in their quotation the spread (bid/offer and other transaction costs).
Other restrictions :
- Banks are allowed to open/close rupee accounts in names of their overseas branches/correspondents (except for Pakistani banks operating outside Pakistan).
- Banks are allowed to open/close foreign currency accounts abroad to route foreign funds.
- Banks are free to undertake investments in themoney market and/or debt instruments with
maturity less than one year.
- Banks can allow their import/exporter clients to book forward to hedge their risks.
- Banks are allowed to offer derivative contracts to domestic entities to hedge their borrowing outside India.
Summary :
In this unit, you have learnt the following:
- Forex is one of the largest markets in the world with an extensive application.
- Several factors affect the movement of exchange rates,including fundamental factors and technical factors. The foreign exchange market has particular terminologies And conventions for trading. It is important to understand these conventions to arrive at the right price.
- The activity of trading in forex is highly regulated by the RBI in India. These regulations primarily exist to curb speculation that could cause instability.
Introduction :
Cross-border movement of commodities, services, man power and capital is one of the biggest drivers of the economic activity. This module focuses on understanding the role of banking in this particular area. which is also known as international banking. Exchange rates and the business of dealing in foreign exchange are two important aspects of international banking.
in this unit, you learn about:
- The definition and meaning offoreign exchange
- The mechanism of the foreign exchange (forex) market
- The factors affecting forex rates
- The guidelines relating to forex
- The factors related to dealing in forex
Foreign Exchange Markets :
A Foreign Exchange (forex or FX) transaction is primarily defined as the exchange of one currency (or currency equivalent like traveller cheques and drafts) for another currency by two parties at an agreed price. The ratio at which the Currencies are exchanged is called the exchange rate.
Example
One US Dollar (USD) can be exchanged for approximately 44.8 lndian Rupees (lNR) as of June 2011. Hence, the exchange rate is denoted as 1USD = 44.8 INR. Similarly, 1 EUR = 1.4364 USD.
Forex Participants :
There are various participants that trade foreign currencies.
|
Participants
|
Activity
|
|
1 Exporting companies
|
1 Converting foreign revenues in to domestic revenues
|
|
2 Importing companies
|
2 Converting foreign costs in domestic costs
|
|
3 Commerical banks
|
3 Help customers in need of forex
|
|
4 Investment Funds/Banks
|
4 Transfer funds for investments in or out of foreign
countries
|
|
5 Central Banks
|
5 Manage reserves and FX Rates
The central bank in India is the Reserve Bank
of lndia (RBI)
|
|
6 Individuals
|
6 Make investments and participate in trade
|
Foreign Exchange Management Act :
The Foreign Exchange Management Act (FEMA) is the primary act controlling the activities related to foreign exchange. The Reserve Bank of India (RBI) is responsible for implementing the controls and managing the currency. The forex market is one of the largest markets in existence as various currency pairs are traded around the world. Places like Tokyo, Singapore, Hong Kong, London and New York have been established as the centres of FX trade.
Some characteristics of the forex market are:
- It is practically a twenty four hour market.
- It is a liquid market with many bids and ask offers.
- FX trades happen across the world, but trade in individual currency pairs may be restricted to certain countries because of lack of interest or regulations.
- Markets are affected by Government policies and regulations.
Exchange Rate Market Mechanism :
Certain concepts help in understanding the mechanism of exchange rate markets. It is important to understand these conventions to arrive at the right price.
Delivery Time :
As FX trade is generally conducted across different time zones, the settlement time is an important factor in determining a contract. There are various ways in which the delivery of FX can be settled.
Spot Basis :
This is when the currencies are delivered on the second working day following the day of the deal/contract. The exchange rate used for this purpose is called the spot exchange rate.
Example :
If the date of the deal is on March 6, 2017 (Monday), the settlement date will be on March 8, 2017(Wednesday, provided all the markets involved are working on the March 6, 7 & 8).
Ready/Cash Basis :
This is when the settlemeht takes place on the same day of the deal.
Example :
If the date of the deal is on March 6, 2017 (Monday), the settlement date will also be on March 6, 2017 (Monday).
Tom Basis :
This is when the settlement takes place the day after the deal is made.
Example :
If the date of the deal is on March 6, 2017 (Monday), the settlement date will be on March 7, 2017 (Tuesday, provided it is a working day for all the markets involved). If it so happens that Tuesday is a holiday in either of the two countries, then the settlement date will be the next working day in both the countries involved.
Forward Basis :
This is when settlement takes place on a future date determined on the day the deal is made. The exchange rate used for this purpose is called forward rate.
Example :
If the day of the forward deal is March 6, 2017 (Monday), for settlement date March 22, 2017, it is termed as a forward deal.Spot and Forward Rates While the spot rate is the popularly used rate in the exchange rate market, forward settlement is also often used depending on the needs of both the parties. On any given day there would be several forward rates depending on the future date of settlement. Usually, forward rates are derived from spot rates and are a function of the spot rates and forward premium or discount of the currency being quoted.
Thus, Forward Rate = Spot Rate + Premium (Or — Discount)
The primary determinants of the premium or discount are the time for settlement and the interest rate differential between the two currencies. Hence, the longer the settlement period, the higher the premium or discount. If a domestic currency's interest rate is higher than a foreign currency's interest rate, then the foreign currency would be trading at a premium in the forward rate. This implies that the higher the interest rates in a domestic currency relative to the foreign currency, the higher the forward premium for the foreign currency. The relationship between forward rate and interest rates can be expressed as:
1 +t .r dom
FXfwd = FXspot . -------------
1 +t .r for
Where " t " is time for settlement and " rdom " and " rfor " are domestic and foreign interest rates.
Usually the forward rate is quoted as a premium or a discount to the spot rate of the foreign exchange.The premium or discount can be easily calculated from the market forward rate and market spot rate.
For example:
Scenario 1: USD is trading at a bid of INR 45.4 and an offer of INR 45.6 in the spot market. The mid-rate is INR 45.5. The three month forward USD is trading at a bid of INR 45.95 and an offer of 46.05. The mid—forward rate is INR 46. The forward premium is Rs. 0.5 (46 - 45.5) for three months. This situation happens when interest rates in India are more than interest rates in the US.
Scenario 2: USD is trading at bid of INR 45.2 and an offer of INR 45.3 in the spot market. The mid- rate is INR 45.25. The three month forward USD is trading at a bid of INR 44.95 and an offer of 45.05. The mid-forward rate is INR 45. The fonward discount is Rs. 0.25 (45 - 45.25) for three months.This situation happens when interest rates in India are more than intrest rates in the U.S
Direct and Indirect Quotes
In any country, the exchange market usually quotes its local currency against the US dollar (USD) as well as against other foreign currencies. The direct quotation sets the amount of the local currency required to purchase one unit of the foreign currency as well as the amount of the local currency received when you sell one unit of the foreign currency.
FX in India is quoted as 44.8 USD/INR, (based on rates ofJuly 2011), meaning the dollar is bought/sold for 44.8 INR.
On the other hand, an indirect quote gives the amount of foreign currency required to be exchanged for one unit of the domestic currency. This kind of quote is used when trading the British Pound Sterling (GBP) and Euro (EUR) against the US dollar.
In an indirect quote, the FX rate for INR can be written as 0.0223 INR/USD, meaning one rupee can be bought/sold for 0.0223 US dollars.
Bid and Offered Rates :
Exchange rates, just like other financial quotes, have both bid and offer rates.Bid rate is the rate at which a buyer is willing to buy USD (or any foreign currency in direct quote).Offer rate is the rate at which a seller is willing to sell USD (or any foreign currency).
Example :
When someone says the FX market is at 44.6-45 that means that one dollar can be sold for 44.6 INR (bid rate) and one dollar can be bought for 45 INR (offered rate). The difference between the bid rate and offered rate is called the bid/offer spread and it indicates the liquidity of the market. If the market is highly liquid, the bid/offer spread will be really low.
Cross Rates and Exchange Rate Arithmetic :
Not all currency pairs can be traded in each country, but the exchange rate for certain currency pairs can be derived from the others.
If USD/INR rate is 44.8 and EUR/USD rate is at 1.4364, the EUR/INR rate will be at
44.8 *1.4364 = 64.35 EUR/INR.
This logic can be extended to any currency pair to get the exchange rates for which there is no outright market. While doing so one should be careful to note if the FX rate is quoted by the direct or indirect mechanism.
USD/INR = 44.8 and USD/JPY = 80.22 from this JPY/INR = 0.55 Arbitrage in Exchange Rate
Arbitrage is a financial transaction that involves the purchase of securities (foreign currency, gold, commodities) in one market, for immediate resale on another market, while making a profit without involving any risk.
Formula for Arbitrage in Exchange Rate :
Using the earlier formula, some smart traders are able to look at arbitrage opportunities.
Example :
We calculate the exchange rate for Yen and Rupee as JPY/INR = 0.55
If there is a market for JPY/INR currency pair and it is trading at 0.5, then there is an arbitrage opportunity.To lock in these profits the trader would convert Rupees into USD, then USD into Yen and then finally convert Yen into Rupee.If the investor starts with one rupee, he gets 0.02232 USD, which is equivalent to 0.55 JPY. This when converted back to rupees would be INR 1.1. Thus one rupee invested would give back 1.1 rupees instantly without risks.
However, arbitrage profits decrease and can become zero because of bid/offer spreads in the currencies being traded.
CROSS RATES :
Cross rates are actually affected by bid or offer spreads. The right quotes should be taken to
accurately calculate the bid or offer spread. Instead of taking a single rate, the bid or offer on USD/INR is 4475/4485. This means that one USD can be bought for Rs. 44.85 and one USD can be sold for Rs. 44.75. Similarly if the bid offer on USD/JPY is 80.2/80.24, then one USD can be sold for 80.2 JPY and one USD can be bought for 80.4 Y. From this if the value of selling one JPY and converting it into 1 Rupee is calculated, it would be 1 JPY = 1/80.24 USD =44.85/80.2 INR = 05592 INR. SO the bid offer rate for JPY/INR would be 05577105592.
Factors Determining FX Rates :
There are numerous factors responsible for determining the FX rates. A few of them have been detailed below.
Fixed Versus Floating Rate :
There are two ways the central bank of a country manages its FX rates.
- Fixed Exchange Rate:
Countries where the central bank tries to maintain a constant exchange rate with respect to another currency are said to be adopting a fixed rate regime. For example, the Chinese central bank pegs Yuan to US Dollar at a fixed rate. The fixed rate regime is primarily used to maintain stability, especially for exporters and importers. However, a fixed rate regime can create huge capital account imbalances, thus causing long term instability.
Floating Exchange Rate:
. Countries or economies where the value of currency is free to float based on market dynamics are said to have a floating rate regime. Examples of countries employing this
format include UK, Euro Zone and the United States.The floating rate regime helps in identifying costs of labour and goods. This makes it friendlier towards competitive
players. Some countries like India allow the currency to float, but only within a broad range.
Sometimes a mix of both these factors can also be used.
The currency management mechanism is the most important feature that should be looked at when understanding the factors affecting a currency.
FUNDAMENTAL FACTORS:
The fundamental factors that influence the movement of exchange rates are macro-economic in nature. A few have been detailed below.
- Balance of payments:
Trade surpluses usually strengthen the currency versus foreign currency as a high trade surplus would mean more demand for the currency.
Growth rate:
A high growth rate in the economy would be positive for the currency as more money would flow into the country either through trade or through investments.
Fiscal policy:
The fiscal policy affects the growth rate in the economy and through that the currency, thus having an indirect effect on exchange rates.
Political scenarios:
Political uncertainty can lead to an exodus of capital and a drop in trade and is thus negative
to the currency.
Monetary policy and interest rates:
As long as they do not hamper the growth, high interest rates lead to a greater inflow from foreign investors thereby strengthening the currency.
Technical Factors :
A few of the technical factors influencing exchange rates have been detailed below.
- Risk aversion leads to investors withdrawing money from supposedly risky economies.
- Selling off assets leads to outflow of foreign funds. In fact, there is a strong relationship between equities
- Speculation by various entities can also affect exchange rates.
FX Dealing:
For a bank, forex dealing consists of managing foreign currency assets and liabilities, managing cash flows in various currencies and providing liquidity (quotes) to clients for forex transactions. Forex dealers also actively involve themselves in the forex market trading with various counterparties, either to hedge their risks or to provide liquidity to the market.Forex dealing is a highly specialised job involving instant decision making and continuous tracking of the markets.
The various functions of forex dealing are usually split into:
- Front office — Where the dealer actually provides quotes and closes deals
- Back office — responsible for settlement and accounting
- Mid office — responsible for risk management and regulatory compliance
FX Regulations :
Forex trading undertaken across borders without controls not only exposes the party undertaking these transactions to risks but also creates systemic risk for the country. Thus, it is necessary to procure a licence from the RBI when participating in forex trade. RBI has issued 'Authorised Dealer' (AD) licences to all-India financial institutions. These include PSU banks, foreign and large private banks and a few all-India Non-Banking Financial Companies (NBFCs). Also, RBI has issued Money Changer licenses to a large number of established companies to facilitate currency transfer for tourism purposes.
Apart from RBI, the Foreign Exchange Dealers Association of India (FEDAI) also provides certain guidelines for the operation of forex intermediaries.
Some of these guidelines have been detailed below.
RBI/FEDAI Guidlines :
- Forward contracts can be entered only for an underlying exposure.
- The export bill drawn in foreign currency needs to be crystallised into rupee assets in case of delay in realisation. The crystallisation covers import transactions too.
- All forward contracts should be of a definite amount and the date should be clearly specified.
- The option period can be specified by the customer but the delivery period cannot exceed
a month.
- All currencies should be quoted as per unit of foreign currency, while JPY, Indonesian Rupiah and Kenyan Shilling are to be quoted as 100 units of foreign currency.
- FEDAI guidelines allow the banks to structure in their quotation the spread (bid/offer and other transaction costs).
Other restrictions :
- Banks are allowed to open/close rupee accounts in names of their overseas branches/correspondents (except for Pakistani banks operating outside Pakistan).
- Banks are allowed to open/close foreign currency accounts abroad to route foreign funds.
- Banks are free to undertake investments in themoney market and/or debt instruments with
maturity less than one year.
- Banks can allow their import/exporter clients to book forward to hedge their risks.
- Banks are allowed to offer derivative contracts to domestic entities to hedge their borrowing outside India.
Summary :
In this unit, you have learnt the following:
- Forex is one of the largest markets in the world with an extensive application.
- Several factors affect the movement of exchange rates,including fundamental factors and technical factors. The foreign exchange market has particular terminologies And conventions for trading. It is important to understand these conventions to arrive at the right price.
- The activity of trading in forex is highly regulated by the RBI in India. These regulations primarily exist to curb speculation that could cause instability.
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