Fig 9.1 the Foreign Exchange Market The structure of foreign exchange market constitutes central banks, commercial banks, brokers, Exporters and Importers, Investors, Immigrants at last tourists. RBI delegates power to entities to deal with foreign exchange and foreign securities. Section 2(c) of Foreign Exchange Management Act or FEMA states that ‘authorized person’ means an authorized dealer, money changer, off-shore banking unit or any other person authorized under section 10 (1) to deal in foreign exchange and foreign securities. These are authorized by RBI under section 10 of FEMA to deal in foreign exchange. Generally, all nationalized banks, leading non-nationalized banks and foreign banks are ‘Authorized Dealers Category I’ to deal in foreign exchange. They can deal in all other transactions in foreign exchange like bill of exchange, cheques, letter of credit, deposits etc. They can freely purchase from public in India TTs, MTs, drafts, bills etc. drawn in any foreign currency against rupees. Authorized Dealers – Category II can undertake the following transactions – Private visits and business visits, Remittances of tour operators, Participation in international events, global conferences and specialized training, Medical treatment abroad. Full-fledged money changers, are those who are authorized to undertake both purchase and sale transactions with the public. This was done to facilitate exchange of foreign currency. Reserve Bank has granted licenses to certain established firms, hotels and other organizations 151 CU IDOL SELF LEARNING MATERIAL (SLM)
permitting them to deal in foreign currency notes, coins and travelers’ cheques subject to directions issued to them from time to time. Forex Brokers are important for trading in forex derivatives on stock exchanges. The SEBI has the power and responsibility of providing licenses to forex brokers, or to revoke licenses in cases they fail to comply with the guidelines laid out by them similar to power of RBI with regard to authorized dealers. 9.4 FOREX MARKET PARTICIPANTS Diverse a commodity market, where all participants have access to the same price levels, the forex market is separated into levels of access. At the peak is the interbank industry, which is made up of the most prominent investment funds banking firms. Inside the interbank marketplace, gaps, which are the deviation between the bidding and ask cost, are razor sharp and normally unavailable, and not known to participants outside the inner circle. As you go down the degrees of access, the difference between the bidding and ask costs extends. This is due to mass. If a swing trader can guarantee immense amounts of dealings for huge amounts, they can require a more minor difference between the bidding and ask price, which is named to as a better spreading. The top tier interbank industry accounts for 53% of all transactions. When that there are usually more minor investment banks, followed by heavy multinational corporations (which want to hedge risk and pay employees in diverse countries), big hedge funds, and potentially a few of the retail forex market makers. Major Pension funds, insurance policy companies, mutual funds, and other institutional investors have wagered an increasingly significant role in financial markets in general, and in FX markets in particular, since the early 2000s. 1. Central Banks National primal banks play a please note role in the foreign exchange marketplaces. They seek to check the revenue supply, inflation, and/or interest rates and often have prescribed or unofficial target values for their currencies. They can use their oftentimes substantial foreign exchange reserves to stabilize the marketplace. The strength of primal banking institute stabilizing hypothesis is in question because primal banking firms don't go bankrupt if they make huge losses, like more traders would, and there are no convincing grounds to believe that they do make a profits dealing. 2. Commercial Banks: The major participants in the foreign exchange market are the large Commercial banks who provide the core of market. As many as 100 to 200 banks across the globe actively “make the market” in the foreign exchange. These banks serve their retail clients, the bank customers, in conducting foreign commerce or making international investment in financial assets that require foreign exchange. 152 CU IDOL SELF LEARNING MATERIAL (SLM)
The bulk of activity in the foreign exchange market is conducted in an inter-bank wholesale market-a network of large international banks and brokers. Whenever a bank buys a currency in the foreign currency market, it is simultaneously selling another currency. A bank that has committed itself to buy a certain particular currency is said to have long position in that currency. A short-term position occurs when the bank is committed to selling amounts of that currency exceeding its commitments to purchase it. 3. Investment Funds Management Firms Investing management firms (who occasionally manage vast accounts on behalf of clients such as pension funds and endowments) utilize the foreign exchange industry to facilitate dealings in foreign securities. For instance, an investment funds manager with a worldwide equity portfolio will require choosing and dealing foreign currencies in the area market in order to compensate for purchases of alien stocks. Because the forex trading transactions are secondary to the factor investing decision, they are not seen as speculative or calculated at profit maximization. 4. Commercial Corporations: An important side of this marketplace comes from the financial activities of corporations seeking extraneous exchange to pay for goods or services. Commercial corporations much business deal fairly pocket size amounts likened to those of banks or speculators, and their trades frequently have little short term impact on market merits. However, business deal flows can be and please note ingredient in the semi-permanent direction of a currency’s exchange rate. A few transnational corporations can have an unpredictable impact when very enormous positions could be reported due to exposures that want to be not widely known by more marketplace players. 5. Foreign Exchange Brokers: Foreign exchange brokers also operate in the international currency market. They act as agents who facilitate trading between dealers. Unlike the banks, brokers serve merely as matchmakers and do not put their own money at risk. hey actively and constantly monitor exchange rates offered by the major international banks through computerized systems such as Reuters and are able to find quickly an opposite party for a client without revealing the identity of either party until a transaction has been agreed upon. This is why inter-bank traders use a broker primarily to disseminate as quickly as possible a currency quote to many other dealers. 6. MNCs: MNCs are the major non-bank participants in the forward market as they exchange cash flows associated with their multinational operations. MNCs often contract to either pay or receive fixed amounts in foreign currencies at future dates, so they are exposed to foreign 153 CU IDOL SELF LEARNING MATERIAL (SLM)
currency risk. This is why they often hedge these future cash flows through the inter-bank forward exchange market. 7. Individuals And Small Businesses: Individuals and small businesses also use foreign exchange market to facilitate execution of commercial or investment transactions. The foreign needs of these players are usually small and account for only a fraction of all foreign exchange transactions. Even then they are very important participants in the market. Some of these participants use the market to hedge foreign exchange risk. 9.5 FOREX MARKET POLICIES Foreign exchange market plays a very significant role in business development of a country because of the fact that it performs several useful functions, as set out below: 1. Foreign exchange market transfers purchasing power across different countries, which results in enhancing the feasibility of international trade and overseas investment. 2. It acts as a central focus whereby prices are set for different currencies. 3. With the help of foreign exchange market investors can hedge or minimize the risk of loss due to adverse exchange rate changes. 4. Foreign exchange market allows traders to identify risk free opportunities and arbitrage these away. 5. It facilitates investment function of banks and corporate traders who are willing to expose their firms to currency risks. 9.6 FOREX MARKET STATERGIES A forex trading strategy is a technique used by a forex trader to determine whether to buy or sell a currency pair at any given time. Forex trading strategies can be based on technical analysis or fundamental, news-based events. The trader’s currency trading strategy is usually made up of trading signals that trigger buy or sell decisions. Forex trading strategies are available on the internet or may be developed by traders themselves. Basics of a Forex Trading Strategy Forex trading strategies can be either manual or automated methods for generating trading signals. Manual systems involve a trader sitting in front of a computer screen, looking for trading signals and interpreting whether to buy or sell. Automated systems involve a trader developing an algorithm that finds trading signals and executes trades on its own. The latter systems take human emotion out of the equation and may improve performance. 154 CU IDOL SELF LEARNING MATERIAL (SLM)
Traders should exercise caution when purchasing off-the-shelf forex trading strategies since it is difficult to verify their track record and many successful trading systems are kept secret. Creating a Forex Trading Strategy Many forex traders start with a simple trading strategy. For example, they may notice that a specific currency pair tends to rebound from a particular support or resistance level. They may then decide to add other elements that improve the accuracy of these trading signals over time. For instance, they may require that the price rebound from a specific support level by a certain percentage or number. There are several different components to an effective forex trading strategy: Selecting the Market: Traders must determine what currency pairs they trade and become experts at reading those currency pairs. Position Sizing: Traders must determine how large each position is to control for the amount of risk taken in each individual trade. Entry Points: Traders must develop rules governing when to enter a long or short position in a given currency pair. Exit Points: Traders must develop rules telling them when to exit a long or short position, as well as when to get out of a losing position. Trading Tactics: Traders should have set rules for how to buy and sell currency pairs, including selecting the right execution technologies. Traders should consider developing trading systems in programs like Meta Trader that make it easy to automate rule-following. In addition, these applications let traders back test trading strategies to see how they would have performed in the past. Time to Change Strategies A forex trading strategy works really well when traders follow the rules. But just like anything else, one particular strategy may not always be a one-size-fits-all approach, so what works today may not necessarily work tomorrow. If a strategy isn't proving to be profitable and isn't producing the desired results, traders may consider the following before changing a game plan: 155 CU IDOL SELF LEARNING MATERIAL (SLM)
Matching risk management with trading style: If the risk vs. reward ratio isn't suitable, it may be cause to change strategies. Market conditions evolve: A trading strategy may depend on specific market trends, so if those change, a particular strategy may become obsolete. That could signal the need to make tweaks or modifications. Comprehension: If a trader doesn't quite understand the strategy, there's a good chance it won't work. If a problem comes up or a trader doesn't know the rules, the effectiveness of the strategy is lost. Although change can be good, changing a forex trading strategy too often can be costly. If you modify your strategy too often, you could lose out. 9.7 RECENT DEVELOPMENTS IN INDIA The Reserve Bank developed and strengthened various segments of the financial markets by broadening participation, easing access and transaction norms, improving financial market infrastructure and pursuing rigorous surveillance to maintain market integrity. Management of liquidity conditions, accordingly, became a dominant objective during the year. The Reserve Bank used several unconventional instruments such as forex swaps, long-term repo, targeted long-term repo, short-term forex swaps and variable rate reverse repo. Several measures were undertaken during the year to streamline regulations relating to the foreign exchange markets to align them with the current business and economic environment. (1) During 2019-20, the Reserve Bank undertook several measures to develop the financial markets further in terms of broadening the participation base in various segments of the markets, easing access and transaction norms, expanding the range of financial products, simplifying procedures and improving financial market infrastructure, while maintaining rigorous surveillance to ensure market integrity. The Reserve Bank’s liquidity management operations, in rupees and forex, were stepped up and unconventional instruments were also deployed to ensure adequate liquidity, the normal functioning of markets and the stability of the financial system in the face of the dislocation caused by COVID-19. (2) Against this backdrop, section 2 covers the measures undertaken to develop the financial markets. Section 3 presents liquidity management and foreign exchange market operations. Section 4 covers various initiatives undertaken to facilitate trade and payments 156 CU IDOL SELF LEARNING MATERIAL (SLM)
while promoting orderly development of the foreign exchange market. The agenda for 2020- 21 has been covered in each section. Financial Markets Regulation Department (FMRD) (3) The FMRD is entrusted with the development, regulation and surveillance of money, government securities (G-secs), foreign exchange and related derivatives markets. The Department undertook several measures in pursuance of this mandate to fulfil the objectives set for 2019-20. Agenda for 2019-20: Implementation Status Goals Set for 2019-20 (4) The Department had set out the following goals for 2019-20: To develop an IT-enabled Integrated Market Surveillance System (IMSS) for augmenting the surveillance capacities (Utkarsh) [Para V.5]; To implement international settlement of central government securities through International Central Securities Depositories (ICSDs) to permit non-resident clients of ICSDs to transact in central government securities offshore (Para V.6); and Review and implementation of various financial market timings as recommended by the Internal Group set up in August 2018 (Para V.7). Implementation Status of Goals (5) The Department is in the process of implementation of the Integrated Market Surveillance System. Expression of Interest (EOI) have been obtained from the interested vendors. Based on the evaluation of EOI, the Department shall be issuing the Request for Proposal (RFP) by end of August 2020. (6) As regards the implementation of international settlement of Indian G-sec through ICSDs, the draft scheme has been finalized in consultation with the government. There are, however, certain tax issues which have been referred to the government. Meanwhile, the operational details of the ICSD scheme are being chalked out, and will be finalized shortly. 157 CU IDOL SELF LEARNING MATERIAL (SLM)
(7) As recommended by the Internal Group on market timings and the feedback received from the market participants, the revised market timings for various products have been finalized, and shall be implemented, once COVID-19 related dislocations stabilize. Easing Access, and Broadening Participation in the Foreign Exchange Market (8) For the domestic foreign exchange market, the initiatives undertaken during the year focused on incentivizing access, bridging the segmentation between onshore and offshore trading activity, and simplifying the hedging of foreign exchange risks, while safeguarding the interests of less sophisticated participants Non-Resident Investment in Domestic Debt Instruments (9) A separate route, viz., Fully Accessible Route (FAR) for investment by non-residents in securities issued by the Government of India was introduced on March 30, 2020, in line with an announcement in the Union Budget 2020-213. This will be the third route, in addition to investment under the medium-term framework and the voluntary retention route (VRR) for investment by non-residents in the debt segment. A list of five existing securities have been notified as eligible for investment under the FAR. In addition, all new issuances of government securities of 5-year, 10-year and 30-year tenors from 2020-21 will be eligible for investment under the FAR. While the tenors of new securities to be designated as ‘specified securities’ may be added/amended from time to time, a security, once designated as eligible for investment under the FAR, shall remain eligible till maturity. (10) Several measures were undertaken to further liberalize/facilitate the Foreign Portfolio Investors’ (FPI) investments in debt instruments: (a) the limit for investment by an FPI in short-term (up to one year) corporate bonds and government securities, including treasury bills and State Development Loans (SDLs), was revised on January 23, 2020, to 30 per cent from the existing 20 per cent of the total investment by that FPI in the respective category; (b) debt instruments issued by Asset Reconstruction Companies (ARC) or by entities under the Corporate Insolvency Resolution Process under the Insolvency and Bankruptcy Code, 2016 were exempted from the short-term investment limit; and (c) the limit for investment by FPIs in corporate bonds was raised to 15 per cent of outstanding stock with effect from April 1, 2020 (from 9 per cent), in line with an announcement in the Union Budget 2020-21 . 158 CU IDOL SELF LEARNING MATERIAL (SLM)
(11) The investment cap under the VRR was increased to ₹1,50,000 crore from the existing ₹75,000 crore on January 23, 2020 in order to encourage long-term portfolio investment in the Indian debt markets. FPIs, which were allotted investment limits under VRR, were permitted to transfer their investments made under the General Investment Limit to the VRR. Under the VRR scheme, FPIs were also allowed to invest in Exchange-Traded Funds (ETF) that invest only in debt instruments. Units of debt ETF were allowed as eligible securities for repo transactions on November 28, 2019 with a view to expanding the eligible collateral base in repo market and also to improve liquidity. In view of the disruptions caused by COVID- 19, FPIs that were allotted limits under VRR between January 24, 2020 (the date of reopening of allotment of investment limits) and April 30, 2020, have been given an additional time of three months to invest 75 per cent of their Committed Portfolio Size (CPS). The retention period for the investments will be reset accordingly. Improving Financial Market Infrastructure (12) A regulatory framework for financial benchmark administrators was introduced in June 2019 to improve the governance of the benchmark-setting processes in financial markets regulated by the Reserve Bank. Six benchmarks administered by Financial Benchmarks India Pvt. Ltd. (FBIL) were notified by the Reserve Bank as ‘significant benchmarks’ on January 1, 2020. (13) The Reserve Bank mandated the use of Legal Entity Identifier (LEI) for participation in non-derivative markets in November 2018. In the context of the difficulties expressed by market participants due to COVID-19, and with a view to enabling smoother implementation of the LEI system in non-derivative markets, the timeline for implementation of LEI was extended from March 31 till September 30, 2020. Agenda for 2020-21 (14) For the year 2020-21, the Department proposes to achieve the following goals: As announced in the Reserve Bank’s Statement on Developmental and Regulatory Policies of February 6, 2020, and in line with G-20 recommendations, a framework for exchange of initial and variation margin for non-centrally cleared derivative contracts will be put in place. Such exchange of margin shall be facilitated by the adoption of the legislation for bilateral netting of qualified financial contracts as announced in the Union Budget 2020-21 (Utkarsh); 159 CU IDOL SELF LEARNING MATERIAL (SLM)
Directions on Credit Default Swaps (CDS) will be reviewed with a view to broadening the base of CDS writers and simplifying operational guidelines so as to strengthen the corporate bond market in the light of the proposed legislation on bilateral netting of qualified financial contracts (Utkarsh); and Review the Directions on Interest Rate Derivatives with a view to easing access, removing segmentation between onshore and offshore markets and improving transparency. Financial Markets Operations Department (FMOD) (15) The Financial Markets Operations Department (FMOD) is entrusted with two primary responsibilities: first, conduct of liquidity management operations for maintaining an appropriate level of liquidity in the financial system for monetary policy transmission; and second, ensuring orderly conditions in the forex market through operations in the spot, forward and futures segments. Agenda for 2019-20: Implementation Status Goals Set for 2019-20 (16) During the year, the Department had set out the following goals: To monitor evolving liquidity conditions closely and to modulate operations to ensure alignment of the WACR with the policy repo rate (Para V.17); To conduct foreign exchange operations in an effective manner to curb undue volatility in the exchange rate (Para V.23); and To launch a “Public Register” in collaboration with India Foreign Exchange Committee as part of the adoption of principles of “FX Global Code” in the domestic forex market (Utkarsh) [Para V.24]. Implementation Status of Goals Money Market and Liquidity Management (17) As system liquidity shifted from deficit during April-May 2019 to surplus from June 2019, the Reserve Bank actively managed evolving liquidity conditions through use of fine- tuning instruments under the Liquidity Adjustment Facility (LAF), Open Market Operations (OMOs) and variable rate reverse repo operations of both shorter and longer tenors. 160 CU IDOL SELF LEARNING MATERIAL (SLM)
(18) Under the new liquidity management framework announced on February 6, 2020, the Reserve Bank deployed several new instruments tailored to the India-specific situations and drawing from the international experience (Box V.2) (19) On the basis of an assessment of the existing liquidity conditions, the daily fixed rate repo and four 14-day variable rate repos, being conducted earlier every fortnight, were withdrawn with effect from February 14, 2020. The daily MSF and fixed rate reverse repo were retained. Furthermore, as a part of the revised liquidity management framework, two new instruments, Long-Term Variable Rate Repo (LTR) and Long-Term Variable Rate Reverse Repo (LTRR), with tenors of more than 14 days, were also announced. (20) In view of the exceptionally high volatility in domestic financial markets which brought in phases of liquidity stress and to provide comfort to the banking system; on March 27, 2020, the borrowing limit of scheduled banks under the Marginal Standing Facility (MSF) scheme, by dipping into the prescribed Statutory Liquidity Ratio (SLR), was increased from 2 per cent to 3 per cent of their Net Demand and Time Liabilities (NDTL) outstanding at the end of the second preceding fortnight. This relaxation which was available up to June 30, 2020 was extended till September 30, 2020 on June 26, 2020. Box V.2: Unconventional Tools of Liquidity Management: The Recent RBI Experience In the post global financial crisis period, several central banks introduced new policy instruments and made changes to their monetary policy frameworks. Often labelled as “unconventional monetary policy tools” (UMPTs), four broad categories are discernible in the cross-country experience: negative interest rate policy; expanded lending operations; asset purchase programmes; and forward guidance (BIS, 2019). Another important element of unconventional monetary policy is provision of liquidity support to the banks on a large scale. For instance, the ECB shifted since October 2008 towards Long-term Refinancing Operations, which are mainly executed on a monthly basis for maturities ranging from six months to twelve months (Pattipeilohy, et al. 2013). The circumstances under which central banks resort to unconventional monetary policy and liquidity management is a key issue. It is argued that when there is little or no room for a reduction in nominal interest rate/policy rate (zero lower bound), unconventional measures 161 CU IDOL SELF LEARNING MATERIAL (SLM)
are to be taken in order to continue the supply of liquidity in the financial and banking system and various other sectors of the economy (IMF, 2013). In India, the Reserve Bank undertook a bouquet of unconventional liquidity management measures in 2020 to ensure normal flow of finance into the economy, and enable better transmission of monetary policy impulses in the wake of the unprecedented situation created by the COVID-19 pandemic: From February 17, 2020 and up to March 18, 2020, the Reserve Bank conducted long-term repo operations (LTROs) of one-year and three-year tenors and allotted a total amount of ₹1,25,117 crore at the policy repo rate. The Reserve Bank introduced another unconventional liquidity management tool - Targeted Long-Term Repo Operations (TLTROs) under which liquidity availed by banks was to be deployed in investment grade corporate bonds, commercial paper and non-convertible debentures over and above the outstanding level of their investments in these bonds as on March 27, 2020. An amount of ₹1,00,050 crore was taken by the banks under TLTRO. On April 17, 2020, the Reserve Bank introduced Targeted Long-Term Repo Operations (TLTRO) 2.0 at the policy repo rate for tenors up to three years in order to provide liquidity to small and mid-sized corporates, non-bank financial companies (NBFCs) and microfinance institutions (MFIs). An amount of ₹12,850 crore was taken by the banks under TLTRO 2.0. In order to deal with the liquidity strains on mutual funds (MFs), and potential contagion effects therefrom, the Reserve Bank introduced a special liquidity facility (SLF-MF) of ₹50,000 crore targeted towards MFs for 90 days tenor at the fixed repo rate. Out of the total amount of ₹50,000 crore envisaged, a total amount of ₹2,430 crore was availed under SLF-MF. The LTRO received an overwhelming response, with average bid-cover ratio of 4.5 for the five auctions. Auctions under the TLTRO also received a positive response from market participants, with average bid-cover ratio of 3.3 over the first four auctions. However, the first tranche of TLTRO 2.0 received lower than anticipated response at just 51 per cent of the notified amount of ₹25,000 crore that was auctioned on April 23, 2020 (Chart 1). The total amount injected through LTRO, TLTRO and TLTRO 2.0 stood at ₹2,38,017 crore 162 CU IDOL SELF LEARNING MATERIAL (SLM)
Public sector banks, followed by private sector banks, were the major groups of participants in the LTRO auctions, altogether accounting for an average share of 89 per cent of the total allotted amount. Barring the last auction of March 18, 2020, foreign banks and cooperative banks also had a fair share in the total allotted amount of LTRO (Chart 2). In case of TLTROs, the average percentage share of public sector banks and private sector banks hovered around 99 per cent, with the former remaining the major group of borrowers (Chart 3). The Reserve Bank has thus used an armory of unconventional tools to manage liquidity in the banking and financial system. 163 CU IDOL SELF LEARNING MATERIAL (SLM)
(21) With regard to durable liquidity, the frequency and quantum of OMOs were increased during H2:2019-20. For the year as a whole (April-March 2019-20), the Reserve Bank conducted OMO purchases (including NDS-OM) to the tune of ₹1,45,690 crore, and OMO sales (including NDS-OM) to the tune of ₹32,121 crore, of which, ₹92,385 crore of OMO purchases and ₹32,111 crore of OMO sales were conducted in H2 alone. This included five simultaneous purchase of long-term and sale of short-term government securities under OMOs (December 23 and 30, 2019, January 6 and 23, 2020, and April 27, 2020). During 164 CU IDOL SELF LEARNING MATERIAL (SLM)
April-May 2020, OMO purchases and sales (including NDS-OM) to the tune of ₹1,30,474 crore and ₹10,000 crore were conducted respectively. Subsequently, on July 2, 2020, the Reserve Bank conducted another simultaneous purchase of long-term and sale of short-term government securities under OMOs. Reflecting these operations, the 10-year G-sec generic yield softened cumulatively by 15 basis points (bps) between December 19, 2019 and January 31, 2020. (22) FX swap auctions were actively used as an instrument to manage liquidity in the foreign exchange market in 2019-20. The first USD/INR sell/buy swap auction, amounting USD 2 billion for a period of 6 months, was conducted on March 16, 2020. The Reserve Bank also conducted another 6-month USD/INR sell/buy swap auction of amount USD 2 billion on March 23, 2020 to provide liquidity in the foreign exchange market. Further, in May 2020, the Reserve Bank decided to extend a line of credit of ₹15,000 crore to the Export Import (EXIM) Bank for a period of 90 days from the date of availment with rollover up to a maximum period of one year so as to enable it to avail a US dollar swap facility to meet its foreign exchange requirements in the backdrop of the COVID-19 pandemic. Foreign Exchange Market (23) Orderly conditions were maintained in the forex market during the year through operations in the OTC and Exchange Traded Currency Derivatives (ETCD) segments. (24) As part of the Reserve Bank’s commitment for adoption of the principles of ‘FX Global Code’ in the domestic forex market, the Department [in coordination with India Foreign Exchange Committee (IFXC)] launched a “Public Register”, hosted on the website of the Foreign Exchange Dealers Association of India (FEDAI). It provides the Statement of Commitment of all AD Category-I banks operating in the Indian forex market as well as corporates demonstrating their recognition of, and commitment to adopt the good practices set forth in the FX Global Code. The register is already linked with the global public register hosted by Global Foreign Exchange Committee (GFXC). The “Public Register” acts as a repository of information to facilitate market participants to publicize their Statements of Commitment to the FX Global Code and also to assist interested parties in identifying market participants. The Reserve Bank has hosted its own Statement of Commitment in the Central Bank Public Registry maintained by the Bank for International Settlements (BIS). 165 CU IDOL SELF LEARNING MATERIAL (SLM)
Agenda for 2020-21 (25) During the year, the Department plans to focus on the following: To carry out liquidity management operations effectively, including through additional liquidity management tools, in line with the stance of monetary policy (Utkarsh); To monitor evolving liquidity conditions closely and to modulate operations to ensure alignment of the WACR with the policy repo rate; To conduct foreign exchange operations in an effective manner to curb undue volatility in the exchange rate; and To continue policy-oriented research on financial markets. Foreign Exchange Department (Fed) (26) During the year, the Department engaged in carrying forward rationalization of regulations with a view to moving towards a more principles-based regulatory framework. The Department also undertook several steps for enhancing ease of doing business, including aligning the regulatory framework to respond to needs of the current business and economic environment, in order to facilitate external trade and payments. Agenda for 2019-20: Implementation Status Goals Set for 2019-20 (27) The Department had set out specific deliverables for 2019-20 in pursuit of its mission: Creation of a detailed framework for enhancing FEMA awareness (Utkarsh) [Para V.28]; Developing internal frameworks for granting approvals (Utkarsh) [Para V.29]; Building a fee structure for minor violations of FEMA (Utkarsh) [Para V.30]; Review and rationalization of entry norms for being licensed as Full-Fledged Money Changers (FFMCs) [Para V.31]; Rationalization of guidelines relating to merchanting trade transactions (Para V.36); Enhancing the scope of Special Non-Resident Rupee (SNRR) Account (Para V.39); Relaxing the end-use of external commercial borrowings (ECBs) [Para V.40]; and Notification of Non-Debt Rules under the FEMA (Para V.42). Implementation Status of Goals V.28 Alongside efforts to simplify regulations, regional offices (ROs) of the Foreign Exchange Department have also been active in disseminating information by organizing various conferences, seminars, exhibitions and financial literacy programmes for different 166 CU IDOL SELF LEARNING MATERIAL (SLM)
target groups. ROs have also been an important channel of securing constructive feedback from the actual users of foreign exchange, viz., Authorized Persons (APs) and Exporters/Importers. With the objective of streamlining various FEMA related events, a detailed framework was issued to the ROs for conducting such events. (29) The Department developed internal frameworks for granting approvals in areas such as Liberalized Remittance Scheme (LRS) and Overseas Direct Investment (ODI)-Foreign Direct Investment (FDI) structures. (30) Late Submission Fee (LSF) was introduced, in lieu of compounding process, for certain reporting violations under FEMA in respect of ECBs. The fees can be collected and remitted by Authorized Dealers (ADs) for regularizing such violations. Authorized Persons and Remittances (31) The guidelines on money changing and merchanting activities were rationalized. Definitions of categories of authorized persons licensed by the Reserve Bank under FEMA were incorporated in the guidelines. The prescription on age of directors of FFMCs was aligned with the provisions of the Companies Act, 2013. Companies registered under the Registration of Companies (Sikkim) Act, 1961 were made eligible to apply for FFMC license. (32) A comprehensive review was undertaken for simplification of reporting requirements of regulated entities and enhancing the role of APs, with a view to reducing transaction costs. An online package for FFMCs/upgraded FFMCs (AD Category II) relating to licensing, renewal, reporting, cancellation and inspection is being developed by the Reserve Bank Information Technology Pvt. Ltd. (ReBIT) which will rationalize reporting and reduce manual handling of other work processes. Trade Guidelines - Liberalization and Rationalization (.33) An auto-emailing feature was developed in the Import Data Processing and Monitoring System (IDPMS) and the Export Data Processing and Monitoring System (EDPMS), with a view to enabling self-monitoring by importer/exporter of import/export transactions pending reconciliation. System-generated e-mails are sent to all importers/exporters at regular 167 CU IDOL SELF LEARNING MATERIAL (SLM)
intervals, giving details of their shipping bills, bills of entry and outward/inward remittances remaining outstanding beyond prescribed due dates. (34) With effect from November 22, 2019, the guidelines on re-export of unsold rough diamonds from Special Notified Zone of Customs were modified. In terms of revised instructions, the Bill of Entry shall be filed by the buyer for the lot(s) of imported rough diamonds meant to be traded by diamond mining companies. These are to be cleared at the centre(s), which are duly notified under Customs Act, 1962/specified by the Central Board of Indirect Taxes & Customs, Department of Revenue, Ministry of Finance, Government of India. AD banks may permit such import payments after being satisfied with the Bonafede of the transaction. AD banks are also required to maintain a record of such transactions. (35) In order to smoothen the process of obtaining permission of the Reserve Bank for re- exporting of leased aircraft/helicopter and/or engines/auxiliary power units (APUs) re- possessed by the overseas lessor, they were exempted from submission of Export Declaration Form (EDF). (36) In January 2020, a comprehensive review of the Merchanting Trade Transactions (MTT) was undertaken and revised guidelines were issued. The key highlights are: (i) allowing transformation of ‘state of goods’; (ii) online verification of documents on the website of the International Maritime Bureau or respective airlines; (iii) write-off of export leg receivables in certain circumstances, which are beyond the control of merchanting trader; (iv) payment of agency commission under certain conditions, which might necessitate payment of agency commission after the MTT has been initiated; (v) enhancement in limit of the import advance without Stand-by Letter of Credit (SBLC)/bank guarantee to USD 5 lakh; (vi) specifically prohibiting third party payments; (vii) prohibiting issue of Letters of Undertaking (LOU)/ Letters of Credit (LoC) for supplier’s/ buyer’s credit; (viii) earmarking the export advance received for the purpose of import leg payment; and (ix) clarification on parking of export proceeds in exchange earners’ foreign currency (EEFC) account. (37) The Foreign Exchange Management (Manner of Receipt and Payment) Regulations, 2016 were amended in March 2020 to include Japanese Yen as a currency of settlement under Asian Clearing Union (ACU) mechanism. 168 CU IDOL SELF LEARNING MATERIAL (SLM)
(38) In view of the outbreak of COVID-19, the period of realization and repatriation to India of the amount representing the full export value of goods or software or services exported up to July 31, 2020 was increased from nine months to fifteen months from the date of export. Similarly, the time period for completion of remittances against normal imports (i.e., excluding import of gold/diamonds and precious stones/jewellery) was extended from six months to twelve months from the date of shipment for such imports made on or before July 31, 2020 (except in cases where amounts are withheld towards guarantee of performance). Non-Resident Rupee Account - A Review of Policy (39) The scope of Special Non-Resident Rupee (SNRR) Account was enhanced by permitting persons resident outside India to open non-interest-bearing SNRR accounts for transactions in INR pertaining to ECBs, trade/trade credits and business-related transactions by International Financial Service Centre (IFSC) Units at Gujarat International Finance Tec (GIFT) City. Restriction on the tenure of SNRR Account - 7 years at present - was also removed for the aforesaid purposes. External Commercial Borrowings Framework - Policy and System Changes (40) The Reserve Bank, in consultation with the Government of India, relaxed the end-use restrictions relating to ECBs for working capital requirements, general corporate purposes and repayment of rupee loans. Eligible borrowers are now allowed to raise ECBs for the afore-mentioned purposes from recognized lenders, except foreign branches/overseas subsidiaries of Indian banks, subject to maintaining the defined average maturity period. Relaxations also include permitting eligible borrowers to avail ECBs for repayment/assignment of rupee loans, classified as SMA-2 or NPA, subject to meeting certain conditions . (41) Work on implementing a Software Platform for External Commercial Borrowings and Trade Credits Reporting and Approval (SPECTRA) encompassing the whole lifecycle from receipt of application to communication of decision and reporting of transactions is underway with NSEIT Limited being awarded the work order in November 2019. Notification of Non-Debt Instrument Rules 169 CU IDOL SELF LEARNING MATERIAL (SLM)
(42) Amendments were made to the FEMA, 1999 through the Finance Act, 2015. In terms of the amended provisions of the Act, the Government of India has been given the powers to frame rules for any class or classes of capital account transactions not involving debt instruments, while the powers to regulate capital account transactions involving debt instruments will continue to be with the Reserve Bank. Furthermore, the government will make rules which lay down the instruments to be determined as debt instruments. Central government notified the amendments vide notification dated October 15, 2019. Non-Debt Instrument (NDI) rules were notified with effect from October 17, 2019. FEMA Related Events – Dissemination of Information and Feedback (43) The Department is continuously striving to upgrade skills and disseminate knowledge by organizing meetings/conferences with in-charges of the ROs with a view to resolving their queries and also gauging the grassroots requirement in the area of foreign exchange management in order to address their issues promptly. The Department has also conducted various knowledge-sharing sessions for the benefit of staff attached to the Central Office and across all the ROs. The various guidelines/instructions are also disseminated by way of regular updation of master directions, training modules and frequently asked questions (FAQs). Agenda for 2020-21 (44) The Department’s strategy for 2020-21 is to focus on consolidating and carrying forward all the initiatives which were undertaken in the previous year. The emphasis will remain on ensuring that the FEMA operating framework is in sync with the needs of the evolving macroeconomic environment. Accordingly, the Department has formulated the following strategic action plan for 2020-21: Undertaking a complete review of the reporting requirements under various regulations in order to make the reporting aligned with specific requirements and make the process simple and efficient (Utkarsh); Introduction of late submission fee for delayed reporting of Overseas Direct Investment (ODI) by Indian Parties/ Resident Indians (Utkarsh); Rationalization of ODI regulations to make them simpler and more principles-based (Utkarsh); 170 CU IDOL SELF LEARNING MATERIAL (SLM)
Conducting awareness programmes and creation of digital content on an ongoing basis (Utkarsh); and Rationalization of various provisions on foreign exchange and currency under Foreign Exchange Management Regulations, 2015, such as export and import of currency; realization, repatriation and surrender of foreign exchange; possession; and retention of foreign currency. These provisions, which are currently covered in four different notifications under the FEMA, would be unified under a single regulation. 9.8 SUMMARY Forex Market is the organizational framework within which banks, merchants, firms, investors, individuals and government exchange foreign currencies for one another. Forex trading strategies are the use of specific trading techniques to generate profits from the purchase and sale of currency pairs in the forex market. Manual or automated tools are used to generate trading signals in forex trading strategies. Traders working on their own trading systems should back test their strategies and paper trade them to ensure that they perform well before committing capital. Forex market has no geographical location, it is electronically linked network Interbank foreign exchange Trading is regulated by the Foreign Exchange Dealers Association of India (FEDAI) 9.9 KEYWORDS FEMA- Foreign Exchange Management Act FERA-Foreign exchange regulation Act FEDAI - Foreign Exchange Dealers Association of India MNC’s – Multi National Companies 9.10 LEARNING ACTIVITY 1. Learn about the GIFT city located in Gujarat and why it is called International Financial HUB ___________________________________________________________________________ ___________________________________________________________________________ 9.11 PRATICAL APPLICATIONS Ostin Ltd is an Irish company that supplies booking software to the hotel industry, selling to the Irish, French and German markets. Turnover was EUR 3.5m in 2013, and the company 171 CU IDOL SELF LEARNING MATERIAL (SLM)
currently has bank facilities of EUR 350K (with the overdraft drawn to EUR 330k). The company operates a EUR account in their local branch. They have recently secured a 3 year contract to supply their software to a large UK hotel chain. The contract is priced in GBP and the hotel chain is due to pay them a quarterly licensing fee of GBP 200k. The first of these payments will be made in January 2015. The company also has ad-hoc expenses in the UK from time to time, which they currently pay in EUR. Separately, the company has carried out a feasibility study about the merits of entering the US market, and has spotted an opportunity. To exploit this fully, their local EI Development Advisor has advised that they will need to establish a presence in the US. The company plan to rent office space, and to employ 4 full time sales representatives in the US. The projected monthly cost of this is USD 25k and they plan to pay this from existing EUR income. They estimate that it will take 6 months before they earn revenues in the US. The Financial Controller has no previous experience with FX, but has been asked by his CEO to put a Risk Management policy in place. 9.12 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. List out the Forex market participants 2. What are Forex Policies 3. List out the Strategies adopted by Indian forex markets 4. Define the term Policies in General. 5. How could you make the market structure more flexible to operate? Suggest 2 ways. Long Questions 1. Briefly explain the Forex market structure 2. Explain the Forex market participants and their approach towards the market 3. Explain the Strategies adopted by Indian forex markets 4. Explain the concept and usage of Forex Policies 5. Explain the term Forex market structure? B. Multiple Choice Questions 172 1. The selling rate is also known as a. bid rate b. offer rate c. spread CU IDOL SELF LEARNING MATERIAL (SLM)
d. None of these 2. In direct quotation the principle adopted by the bank is to a. buy low only b. buy low; sell high c. buy high; sell low d. None of these 3. The term risk in business refers to- a. chance of losing business b. chance of making losses c. uncertainty associated with expected event leading to losses or gains d. threat from competitors 4. Which of the following steps will help the situation where in the local currency of a country is depreciating? a. Decrease the FII holding in the stock market b. Increase the FII holding in the stock market c. Stricter rules for inflow of foreign capital in the country d. None of these 5. A call option of strike price 50 is available at premium of 0.75 when the spot price is 50.50. If the spot price increases the premium will decline. a. Always true b. Never true c. Sometimes true d. none Answers 5-b 1 -b 2 – b 3 – a 4-b 9.13 REFERENCES OP Aggarwal, Trade and forex exchange, Himalaya Publications, 8th Edition 173 Ranjit Singh, Forex Trading: RT Publications Shah Paresh, Forex Management, Wiley CU IDOL SELF LEARNING MATERIAL (SLM)
Ankit Gala and Jitendra Gala; Foreign Exchange and Forex Trading, Buzzing stock Publishing House Peters Jelle: Forex for Ambitious Beginners: Odyssean Publishing Sudhir Kochhar: Foreign Exchange Operations under FEMA: Bloomsbury Publishing (IN) 174 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT - 10: FOREIGN EXCHANGE AND HEDGING TECHNIQUES Structure 10.0 Learning Objectives 10.1 Introduction 10.2 Foreign Exchange Risk Management 10.3 Hedging Techniques and Forex Market Structure 10.4 Swap Options in Forex 10.5 Hedging Currency Risk 10.6 Summary 10.7 Keywords 10.8 Learning activity 10.9 Practical Applications 10.10 Unit End Questions 10.11 References 10.0 LEARNING OBJECTIVES After studying this unit, students will be able to: State the meaning of the term Hedging Learn various Hedging Techniques Outline the off shore banking Techniques 10.1 INTRODUCTION Exchange rates have become more volatile than they were expected. This random fluctuation in exchange rate has made cash flows and asset value of companies dealing in different currencies unpredictable, that is to say, cash flows and asset value of MNCs in their respective domestic currency are at stake of exchange rate between its domestic currency and foreign currency. Thus, Foreign Exchange Exposure is risk associated with unanticipated changes in exchange rate. With globalization and liberalization of Indian economy in nineties, scope of business for Indian companies with the rest of world has broadened and foreign corporations too have become much interested in India. In India, exchange rates were 175 CU IDOL SELF LEARNING MATERIAL (SLM)
deregulated and were allowed to be determined by markets in 1993. This volatility in exchange rates can have detrimental effect on the firm’s financial position and negative effect on its competitive position in the market and value of firm. 10.2 FOREIGN EXCHANGE RISK MANAGEMENT Foreign Exchange risk management includes four stages for managing forex risk 1. Identification and Quantification of Exposure: Business cycle of the company is analysed to identify where foreign exchange risk exists. Future cash flow which are confirm to arise out of contracts already entered and future foreign currency cash flows which are not confirm over the time period are forecasted and measured to get the foreign exchange exposure. After measuring the level of exposure of the company, decision is to be made regarding what magnitude of risk is to be hedged and how much risk is to be covered. 2. Policy Formulation Effective FERM requires well-framed policies, clear objectives and parameters within which the strategy is to be controlled. These policies should clearly mention the principles which is to be followed and extent of hedging (risk coverage) which are needed. Objectives should set standard for bank’s exposure to foreign exchange risk; and personnel are appointed who have the authority to trade in foreign exchange on behalf of company; and should mention the different currencies, which have been approved for transaction within the company. There should be some stop loss arrangements to prevent the firm from abnormal losses if the forecasts turn out wrong. There should be monitoring systems to detect critical levels in the foreign exchange rates where appropriate measure is required. 3. Hedging After formulating policies, the firms then decides about an appropriate hedging strategies keeping in mind the principles and objectives and extent of exposure coverage. There are various financial instruments available for the firm to mitigate its risk- futures, forwards, options and swaps and issue of foreign debt. Hedging strategies and instruments are explained later. 4. Reporting and Review Risk management policies are periodically reviewed based on periodic reports prepared. These periodic reports measure the effectiveness of hedging strategy adopted by the company to mitigate its foreign exchange exposure. The review of risk management policies are done to judge the validity of benchmarks set; whether they are effective in controlling the exposures; what the market trends are and whether the overall strategy is enough or change is required in it. 176 CU IDOL SELF LEARNING MATERIAL (SLM)
10.3 HEDGING TECHNIQUES AND FOREX MARKET STRUCTURE 1. Forward Contracts Forward contracts involve an agreement between two parties to buy/sell a specific quantity of an underlying asset at a fixed price on a specified date in the future. In other words, Forward contracts are those where counterparty agrees to exchange a specified quantity of an asset at a future date for a price agreed today. These are the most commonly used foreign exchange risk management tools. The corporations can enter into forward contracts for the foreign currencies which it need for payment or which it will receive in future. Since the rate of exchange is already fixed for the future transaction, there will be no variability in the cash flows. Hence, changes that take place between the contract date and the actual transaction date does not make any impact. This will eliminate the foreign exchange exposure. The future settlement date can be an exact date or any time between two agreed dates. 2. Currency Futures Currency futures contract involves a standardized contract between two parties to buy/sell an amount of currency at a fixed price on a specified date in the future and are traded on organized exchanges. Futures contracts are more liquid than forward contracts as they are traded in an organized exchange. A depreciation of currency can be hedged by selling futures and currency appreciations can be hedged by buying futures. Thus, inflow and outflow of different currencies with respect to each other can be fixed by selling and buying currency futures, eliminating the Foreign Exchange Exposure. 3. Currency Options Currency options are contracts which provides the holder the right to buy or sell a specified amount of currency for a specified price over a given time period. Currency options give the owner of the agreement the right to buy or sell but not an obligation. The owner of the agreement has a choice whether to use or not to use the option based on the exchange rates. He/she can choose to sell or buy the currency or let the option lapse. The writer of the option gets a price for granting this option. The price payable is known as premium. The fixed price at which the owner can sell or buy the currency is called as strike price or the exercise price. Options giving the holder a right to buy are called call options and Options giving the holder a right to sell is called put options. It is possible to take advantage of the potential gains through currency options. For example, If an Indian business firm has to purchase capital goods from the USA in US$ after three months, the company should buy a currency call option. There are two possibilities. First, if the dollar depreciates, then the exchange rates will be favorable as spot rate will be less than the strike price and the company can buy the US$ at the prevailing spot rate, as it will cost less. Second, if the dollar appreciates, then the exchange rates will be unfavorable as spot rate will be more than the strike price and the 177 CU IDOL SELF LEARNING MATERIAL (SLM)
company can opt to use its right and buy the US$ at the strike price. Hence, in both the cases the company will be paying the less to buy the dollar to pay for the goods. 4. Currency Swaps A currency swap involves an agreement between two parties to exchange a series of cash flows in one currency for a series of cash flows in another currency, at agreed intervals over an agreed period. This is done to convert a liability in one currency to some other currency. Its purpose is to raise funds denominated in other currency. One party holding one currency swaps it for another currency held by other party. Each party would pay the interest for the exchanged currency at regular interval of time during the term of the loan. At maturity or at the termination of the loan period each party would re-exchange the principal amount in two currencies. 5. Foreign Debt Foreign debts are an effective way to hedge the foreign exchange exposure. This is supported by the International Fischer Effect relationship. For example, a company is expected to receive a fixed amount of Euros at a future date. There is a possibility that the company can experience loss if the domestic currency appreciates against the Euros. To hedge this, company can take a loan in Euros for the same time period and convert the foreign currency into domestic currency at the spot exchange rate. And when the company receives Euros, it can pay off its loan in Euros. Hence the company can completely eliminate its foreign exchange exposure. 6. Cross Hedging Cross Hedging means taking opposing position in two positively correlated currencies. It can be used when hedging of a particular foreign currency is not possible. Even though hedging is done in a different currency, the effects would remain the same and hence cross hedging is an important technique that can be used by companies. 7. Currency Diversification Currency Diversification means investing in securities denominated in different currencies. Diversification reduces the risk even if currencies are non-correlated. It will give the company global exposure, minimize foreign exchange exposure and capitalize on exchange rate disparities. 10.4 SWAP OPTIONS IN FOREX Swap: In order to hedge long-term transactions to currency rate fluctuations, currency swaps are used. Agreement to exchange one currency for another at a specified exchange rate and date is termed as currency swap. Currency swaps between two parties are often intermediated by banks or large investment firms. . 178 CU IDOL SELF LEARNING MATERIAL (SLM)
Foreign exchange swap accounts for about 55.6 per cent of the average daily foreign exchange turnover of the world, whereas spot deals account for 32.6 per cent and outright forward for 11.7 per cent. Buying a currency at a lower rate in one market for immediate resale at higher rate in another with an objective to make profit from divergence in exchange rates in different money markets is known as ‘currency arbitrage’. To capitalize on discrepancy in quoted prices, arbitrage is often used to make riskless profits. Exchange rate instability and the collapse of the Bretton Woods System and particularly the control over the movement of the capital internationally, paved the way for the origin of the financial swaps market. Today swaps are at the centre of the global financial revolution. The growth is such that sometimes it looks like unbelievable but it is true. Though its growth will continue or not is doubtful. Already the shaking has started. In the ―plain vanilla‖ dollar sector, the profits for brokers and market makers, after costs and allocation of risk capital, are measured in fewer than five basis points. This is before the regulators catch up and force disclosure and capital haircuts. At these spreads, the more highly paid must move on to currency swaps, tax-driven deals, tailored structures and schlock swaps. The fact which is certain is that, although the excitement may diminish, swaps will stay. Already, swaps have had a major macro-economic impact forging the linkage between the euro and the domestic markets, flattening the cash yield curves, and reducing central bank monopoly influence on markets. We are all swappers now. And remember the saying ―beware of honey offered on a sharp knife‖ when you are offered sweet deals. The problem in following the chaotic process of this very important market is quite simply that ―he who knows does not speak, he who speaks does not know. A glimpse of the growth of swap market and a short list of the nonproprietary tools in the swapper ‘s arsenal is given below: The concept of the SWAPS: The aim of swap contract is to bind the two counterparties to exchange two different payment stream over time, the payment being tied, or at least in part, to subsequent—and uncertain— market price developments. In most swaps so far, the prices concerned have been exchange rates or interest rates, but they increasingly reach out to equity indices and physical 179 CU IDOL SELF LEARNING MATERIAL (SLM)
commodities. All such prices have risk characteristics in common, in quality if not degree. And for all, the allure of swaps may be expected cost saving., yield enhancement, or hedging or speculative opportunity. Portfolio management requires financial swaps which are simple in principle, versatile in practice yet revolutionary. A swap coupled with an existing asset or liability can radically modify effective risk and return. Individually and together with futures, options and other financial derivatives, they allow yield curve and currency risks, and liquidity and geographic market considerations, all to be managed separately and also independently of underlying cash market stocks. Growth of the SWAP Market: In the international finance market most of the new products are executed in a physical market but swap transactions are not. Participants in the swap market are many and varied in their location character and motivates in exciting swaps. However, in general the activity of the participants in the swap market have taken on the character of a classical financial market connected to , and integrating the underlying money, capital and foreign exchange market. Swap in their current form started in 1981 with the well-publicized currency swaps, and in the following year with dollar interest rate swaps. The initial deals were characterized by the three critical features. 1. Barter- two counterparties with exactly offsetting exposures were introduced by a third party. If the credit risk were unequal, the third party- if a bank – might interpose itself or arrange for a bank to do so for a small fee. 2. Arbitrage driven- the swap was driven by an arbitrage which gave some profit to all three parties. Generally, this was a credit arbitrage or market-access arbitrage. 3. Liability driven- almost all swaps were driven by the need to manage a debt issue on both sides. The major dramatic change has been the emergence of the large banks as 180 CU IDOL SELF LEARNING MATERIAL (SLM)
aggressive market makers in dollar interest rate swaps. Major US banks are in the business of taking credit risk and interest rate risk. They, therefore, do not need counterparties to do dollar swaps. The net result is that spreads have collapsed and volume has exploded. This means that institutional investors get a better return on their investments and international borrowers pay lower financing costs. This, in turn, result in more competitively priced goods for consumers and in enhanced returns pensioners. Swap therefore, have an effect on almost all of us yet they remain an arcane derivative risk management tool, sometimes suspected of providing the international banking system with tools required to bring about destruction. Although the swap market is now firmly established , there remains a wide divergence among current and potential users as to how exactly a given swap structure works, what risks are entailed when entering into swap transactions and precisely what ―the swap market‖ is and, for that matter is not. The basic SWAP Structures The growth and continued success of the swap market has been due small part to the creativity of its participants. As a result, the swaps structures currently available and the future potential structures which will in time become just another market ―norm‖ are limited only by the imagination and ingenuity of those participating in the market. Nonetheless, underlying the swap transactions seen in the market today are four basic structures which may now be considered as ―fundamental‖. These structures are: - The Interest Rate Swap - The Fixed Rate Currency Swap - The Currency Coupon Swap - The Basis Rate Swap The Currency SWAP Market: Main Features The oldest and the most creative sector: The currency swap market is the oldest and most creative sector of the swap market. This is not distinguished in market terms between the fixed rate currency swap and the currency coupon swap. There is no distinction in market terms between these two types of currency swaps because the only difference is whether the counter currency receipt/payment is on a fixed or floating basis- in structure and result, the two types of swaps are identical and it is a matter of taste (or preference) for one or both counterparties to choose a fixed or floating 181 CU IDOL SELF LEARNING MATERIAL (SLM)
payment. When the dollar is involved on one side of a given transaction, the possibility to convert a fixed rate preference on one side to a floating rate preference on the other side through interest rate swap market makes any distinction even more irrelevant. However, for those who like fine distinctions, there is a tendency in the market to regard the fixed rate currency swap market as more akin to the long date forward foreign exchange market (because when one is executing a fixed currency swap one may often be competing with the long-date FX market) and the currency coupon swap market as more akin to the dollar bond/ swap market (because the dollar bond issuer compares the below LIBOR spread available in the dollar market to that available, say, through tapping the Swiss Franc market.) Most Interesting Sector of the Swap Market: Whatever distinctions one wishes to draw or not to draw between the two basic types of swaps in the currency swap market, there are many reasons why this market is the most creative and therefore, most interesting sector of the swap market. While still smaller than the dollar interest swap market, the currency swap market has great and perhaps even greater potential for growth than the dollar market, particularly in the light of the growth in local/ Euro capital markets in a wide range of currencies. The Primary and the Secondary Sector: One can classify activity in the currency swap market into the same two basic sectors as the interest swap market – a primary and secondary sector. In the currency swap market, the primary sector is dominant across the yield curve and the key motivating forces underlying this market are ―new money‖ and ―hedging‖ in that order. ―New money‖ or the willingness to execute swap-related public or private financing in one currency to achieve a finer cost or enhanced availability in another currency is the key motivating force behind the currency swap market, particularly for banks and sovereign entities. Such entities have had large capital and refinancing requirements in recent years. The capacity of any one market (e.g.: the Eurodollar bond market) to provide all of these requirements at the finest possible cost has been limited. Hence, many banks and sovereign have been willing to approach the private and public debt markets in currencies for which they have no natural requirements (but which the swap market can use) in order to reduce costs and / or gain greater access to a particular currency which is required. Restructuring, or ―hedging‖ current debt portfolios, cash flows or investments, is clearly an influence of second order is comparisons to the 182 CU IDOL SELF LEARNING MATERIAL (SLM)
influence of ―new money‖. The flexibility of loan repayment clauses and the fact that many corporate and sovereign entities have found their access to a wide range of securities markets greatly expanded in recent years means that even if the fundamental motivation of a currency swap is restructuring/ hedging, this would normally be preceded by an issuer first obtaining a cheaper cost of funds in the base currency through securities or near security transactions. The Creativity: From the market point of view, the driving force of the currency swap market is creativity. Structures in the currency swap market range from the extremely simple to the complex, multi-faceted, multi-counterpart transactions whose economies exist in the dimensions available only to the mathematician. One is limited in the currency swap market only by the problem to be solved, one‘s imagination, the skills of your personal computer operators and of course, the ability of your colleagues to find suitable counterparts around the world at the right time and price. As opposed to the dollar market, where capital commitment has become increasingly important, the key in the currency capital commitment has become increasingly important, the key in the currency swap market is still commitment to creative problem- solving and development of a swap distribution system on a global basis—classic investment banking. Individual Demand and Supply Interplay: ―Warehousing‖ in the primary market is not widespread due to the difficulty of covering the interest rate risks while the swap is in position. A swap arranger can cover the foreign exchange risks associated with ―booking open‖ a position in a given currency but often times the arranger cannot cover against a movement in interest rates for that currency or is forced to use (generally poor) surrogate cover. This is due to the fact that currency swap rates generally move to the laws of their own supply and demand and do not necessarily relate to say, local government bond markets where cover in some currencies can be obtained (particularly sterling and Deutschmarks). But taking of position does not take place among a few selected players and such market-making is not done on a much wider spread basis versus capital market rates than in the dollar interest swap market. However, until better and more consistent relationship between swap rates and the available interest cover develops, position-taking in the currency swap market will remain very much akin to long-date forward foreign exchange dealing and less toward the classic arbitrage model of the swap market. 183 CU IDOL SELF LEARNING MATERIAL (SLM)
The Most Important Currencies of the Swap Market: The most important currencies in the swap market in rough order of magnitude are the Swiss Franc, Yen, Deutschemarks, Pound sterling and Canadian dollar. These currencies are popular in the swap market due to their low interest rates (versus Dollar) and the relative ease of access by a wide range of issuers to private and public debt in the ―Euro‖ and domestic markets of these currencies. Many supranational and sovereign borrowers find their access to the debt markets of such currencies constrained (versus their sometimes quite large requirements) and therefore make extremely active and frequent use of the currency swap market. Such entities either lend in their currencies (and are therefore covering/ matching assets with liabilities) or are trying to diversify their debt portfolios away from the dollar and the costs of the vagaries of that currency can impose on national budgets. Dollar’s Domination: Even after so much development in the swap market, the domination of dollar continues. Though this is also the fact that many direct currency combination continues such as Yen/Swiss Franc. The other high interest rate currencies involved in the currency swap market are viewed as speculative vehicles for aggressive debt portfolio managers or companies in the local market which would have to pay dearly for fixed rate debt. This late comer accounts for the active use of exotic currency debt markets by prestigious international issuers. This has occurred recently in a number of capital markets in which the first few Euro issues are completed at wide divergence to the domestic market rates. Thus, the swaps which become available in this way, have accounted for the presence of many high powered issues. The quality image gained by such issues, should on these markets has gained acceptance for new market and hence, fostered their growth. In sum, the primary sector of the currency swap market is dominated by ―new money‖ considerations by issuers and on the other side, by greater access to a select few low interest- rate debt markets by often the same type of entities. There is, however, a greater diversity by type of participants in the currency swap market than the interest swap market with financial institutions, particularly banks, playing a smaller role in the currency market and sovereigns, supranational and corporate playing a relatively larger role than such entities do in the dollar swap market. Position-taking (capital commitment) is still less important than commitment to 184 CU IDOL SELF LEARNING MATERIAL (SLM)
creativity and distribution capacity among arrangers. While the currency swap market is highly competitive, there is still the possibility to beat your competitor by being smarter, quicker and developing ―niches‖ of special expertise in a particular currency. Highly Opportunistic Sub-sector: The secondary market is a highly opportunistic sub-sector of the currency swap market and, judging by Bankers Trust‘s own activities in this market, the secondary market in currency swaps is relatively larger in comparison to the primary market. Some of the experts are of the view that this is due to a given swap counterparty having two chances to win on interest and exchange rates- in a currency swap and that with the enormous volatility of the dollar, a chance to win big on an exchange rate play. Although the original motivation may be to create a currency swap but the primary motive in the secondary market is to take profit before a currency move places the swap into an unprofitable position. New Breed of Financial Management: The secondary market phenomenon is an inherent part of the new breed of financial management which aggressively manages their cash flows and debt portfolios because they are judged by profits. The spreads tend to be relatively wider in the secondary currency than the secondary interest swap markets, move quickly when an exchange rate breaks is the key to the level of profitability. The exchange rate effects the profitability of a swap reversal is so much that the case of exchange rate that excellent prices and highly attractive rates can be obtained in the secondary market. The reverser needs to move quickly to capitalize on his exchange rate gain. This may lead to the virtual wholesale shutdowns of the primary market in currency swaps. This is so because of the fact that many counterparties want to reverse at the same time. Consequently this will lead to substantial discounts in interest rates on the secondary market versus the primary market. Position-taking and Market-making: Unlike in primary market, the position-taking and market-making are very common in the secondary market due to the excellent pricing available in the secondary market, most of the times. Like the dollar market, sophisticated financial managers are aware that the credit risks are greater in currency swaps. When the time comes to reverse a position these sophisticated financial managers will make a market on the original transactions. 185 CU IDOL SELF LEARNING MATERIAL (SLM)
The fixed rate currency Swap: A fixed rate currency swap consists of the exchange between two counterparties of fixed rate interest in one currency in return for fixed rate interest in another currency. Following are the main steps to all currency swaps: 1. Initial Exchange for the Principal: The counterparties exchange the principal amounts on the commencement of the swap at an agreed rate of exchange. Although this rate is usually based on the spot exchange rate, a forward rate set in advance of the swap commencement date can also be used. This initial exchange may be on a notional basis of alternatively a physical exchange. The sole importance of the initial exchange on being either on physical or notional basis, is to establish the quantum of the respective principal amounts for the purpose of –(i) calculating he ongoing payments of interest and (ii) the re- exchange of principal amounts under the swap. 2. Ongoing Exchanges of Interest: Once the principal amounts are established, the counterparties exchange interest payments based on the outstanding principal amounts at the respective fixed interest rates agreed at the outset of the transaction. 3. Re-exchange of the Principal Amounts: On the maturity date the counterparties re-exchange the principal amounts established at the outset. This straight forward, three-step process is standard practice in the swap market and results in the effective transformation of a debt raised in one currency into a fully-hedged fixed-rate liability in another currency. In principle, the fixed currency swap structure is similar to the conventional long –date forward foreign exchange contract. However, the counterparty nature of the swap market results in a far greater flexibility in respect of both maturity periods and size of the transactions which may be arranged. A currency swap structure also allows for interest rate differentials between the two currencies via periodic payments rather than the lump sum reflected by forward points used in the foreign exchange market. This enables the swap structure to be customized to fit the counterparties exact requirements at attractive rates. For example, the cash flows of an underlying bond issue may be matched exactly and invariably. 186 CU IDOL SELF LEARNING MATERIAL (SLM)
The Currency Coupon SWAP: The currency coupon swap is combination of the interest rate swap and the fixed-rate currency swap. The transaction follows the three basic steps described for the fixed –rate currency swap with the exception that fixed-rate interest in one currency is exchanged for floating rate interest in another currency. By using the currency coupon swap the benefit which can be obtained, can be explained with the following example. Suppose an Indian corporate wished to enter a major leasing contract for a capital project to be sited in Japan. The corporate wanted to obtain the advantage of funding through a Japan‘s lease which provided lower lease rentals due to the Japan tax advantages available to the Japan lessor. However, the Corporate was concerned by both the currency and interest rate exposure which would result from the yen based leasing contract. The structure provided by Hankers Trust enabled the Corporate to obtain the cost benefits available from the Japan lease and at the same time convert the underlying lease finance into a fully –hedged fixed-rate yen liability. Under the structure Bankers Trust paid, on a quarterly basis, the exact payments due on the Corporate‘s yen based Japan lease in return for the Corporate paying an annual amount of fixed Japanese Yen to Banker‘s Trust. The amount for fixed Japanese Yen payable reflected the beneficial level of the Japanese Yen lease payments. The Basis Rates A fast developing area in the international swap markets is the basis rate swap. The structure of the basic rate swap is the same as the straight interest rate swap, with the exception that floating interest calculated on one basis is exchanged for floating interest calculated on a different basis. The forerunner of this type of swap was the US Dollar Prime Rate LIBOR swap. However, an even larger market has developed for the exchange of I month US Dollar LIBOR for 6-month US Dollar LIBOR and more recently US Dollar LIBOR for US Dollar commercial paper at much finer rates than those available on the foreign exchange market. The availability of the basic rate swap market provides an excellent method for entities to arbitrage spreads between different floating rate funding sources. More importantly, it provides a discreet and most efficient method for European entities in particular to stimulate the US Commercial Paper funding market without the necessity of meeting the stringent US requirements for a Commercial Paper programme. To illustrate, consider a transaction structured by Bankers Trust which enabled a European bank to obtain effective 30-day 187 CU IDOL SELF LEARNING MATERIAL (SLM)
commercial paper funding by converting its 6-month US Dollar funding base into 30-day commercial paper via a basis rate swap. The counterparty to the transaction was a second European bank wishing to match its commercial paper funding programme to its LIBOR asset base. SWAP Risk and Exposure The great bulk of swap activity of date has concentrated on currencies and interest rates, yet these do not exhaust the swap concept‘s applicability. As one moves out the yield curve, the primary interest rate swap market becomes dominated by securities transactions and in particular the Eurodollar bond market. The advent of the swap market has meant that the Eurodollar bond market now never closes due to interest rate levels: issuers who would not come to market because of high interest rates now do so to the extent that a swap is available. Indeed, the Eurodollar bond market owes much of its spectacular growth to the parallel growth of its swap market. The firms that now dominate lead management roles in the Eurodollar bond market all have substantial swap capabilities and this trend will continue. One extension is seen in the beginning of the market for equity swaps- an exchange of coupons on some bonds for dividends on some equities, or an index instrument thereof (capital appreciation also may be included on one or both sides of the swap). The purpose is to earn equity returns when the investor deems them promising but without the transactions costs of liquidating an existing bond position or building an outright equities position, while also providing the complication of unfamiliar local market and the time and trouble of stock- picking if the index will suffice. Equity swaps (and, indeed, all swaps) further may be enhanced by options features customized to the interests of the credit worthy, sophisticated investor. Commodities are another fertile area for swaps in view of the limited scope of price protection alternatives. There is modestly growing swap activity in the principal non-ferrous metals, such as copper and aluminium, and rather more in gold, based partly on the advantages of the advantages of the swap investment for protecting long –term project financing vulnerable to price instability. The major focus, however, now lies on petroleum and petroleum products. This is the physical commodity sector most critical to fine economic uses. Since the mid-1980s, this sector has become one of the most heavily traded in the cash and futures market worldwide. 188 CU IDOL SELF LEARNING MATERIAL (SLM)
Essentials for reducing Swap risks: There are certain precautions which are suggested to be taken to reduce the swap risk. They are as follows: 1. Undertaking more stringent credit analyses and use greater care in selecting counterparties: This provides the best insurance against the swap risk. Having a financially strong counterparty not only minimizes the chances of default hut also facilitates the transfer of a swap, for either profit or lack of need, or both. 2. Master agreements: These stipulate the all swaps between two parties are cross-defaulted to each other, default on any one swap triggers suspension payments on all others covered in the agreement. Such arrangements normally pre-suppose frequent transactions between the parties. They also are most effective in reducing exposure when a balance exists in swap positions between paying and receiving fixed rate flows, and between notional principal amounts and maturities. 3. Collateralisation: Collateralization with marketable securities has become an essential feature of swaps with dubious credits. The right to call can be mutual which normally applies only in one direction, depending on the relative strength of the two parties. 4. Better documentation: More protective documentation in swap agreements can provide trigger points for remedial action in advance of actual default. Users could require, for example, that the various tests of financial condition found in credit agreements can provide trigger points for remedial action in advance of actual default. Users could require, for example, that the various tests of Financial condition found in credit agreement are incorporated into swaps contracts. 5. Net settlements: To minimize risk, a swap user is well advised to insist on settlement of all payments on the same day and on a net basis. A payments lag can leave a user vulnerable to loss of its counterparty defaults before the corresponding payment has been made. 189 CU IDOL SELF LEARNING MATERIAL (SLM)
10.5 HEDGING CURRENCY RISK There are a range of hedging instruments that can be used to reduce risk. Broadly these techniques can be divided into (A) Internal Techniques: These techniques explicitly do not involve transaction costs and can be used to completely or partially offset the exposure. These techniques can be further classified as follows: Invoicing in Domestic Currency: Companies engaged in exporting and importing, whether of goods or services, are concerned with decisions relating to the currency in which goods and services are invoked. Trading in a foreign currency gives rise to transaction exposure. Although trading purely in a company's home currency has the advantage of simplicity, it fails to take account of the fact that the currency in which goods are invoiced has become an essential aspect of the overall marketing package given to the customer. Sellers will usually wish to sell in their own currency or the currency in which they incur cost. This avoids foreign exchange exposure but buyers' preferences may be for other currencies. Many markets, such as oil or aluminum, in effect require that sales be made in the same currency as that quoted by major competitors, which may not be the seller's own currency. In a buyer's market, sellers tend increasingly to invoice in the buyer's ideal currency. The closer the seller can approximate the buyer's aims, the greater chance he or she has to make the sale. Should the seller elect to invoice in foreign currency, perhaps because the prospective customer prefers it that way or because sellers tend to follow market leader, then the seller should choose only a major currency in which there is an active forward market for maturities at least as long as the payment period. Currencies, which are of limited convertibility, chronically weak, or with only a limited forward market, should not be considered. The seller’s ideal currency is either his own, or one which is stable relative to it but often the seller is forced to choose the market leader’s currency. Whatever the chosen currency, it should certainly be one with a deep forward market. For the buyer, the ideal currency is usually its own or one that is stable relative to it, or it may be a currency of which the purchaser has reserves. Leading and Lagging: Leading and Lagging refer to adjustments at the time of payments in foreign currencies. Leading is the payment before due date while lagging is delaying payment post the due date. These techniques are aimed at taking advantage of expected devaluation and/or revaluation of relevant currencies. Lead and lag payments are of special importance in the event that forward contracts remain inconclusive. For example, Subsidiary b in B country owes money to subsidiary an in-country A with payment due in three months’ time and with the debt 190 CU IDOL SELF LEARNING MATERIAL (SLM)
denominated in US dollar. On the other side, country B’s currency is expected to devalue within three months against US dollar, vis-à-vis country A’s currency. Under these circumstances, if company b leads -pays early - it will have to part with less of country B’s currency to buy US dollars to make payment to company A. Therefore, lead is attractive for the company. When we take reverse the example-revaluation expectation- it could be attractive for lagging. Netting: Netting involves associated companies, which trade with each other. The technique is simple. Group companies merely settle inter affiliate indebtedness for the net amount owing. Gross intra-group trade, receivables and payables are netted out. The simplest scheme is known as bilateral netting and involves pairs of companies. Each pair of associates nets out their own individual positions with each other and cash flows are reduced by the lower of each company's purchases from or sales to its netting partner. Bilateral netting involves no attempt to bring in the net positions of other group companies. Netting basically reduces the number of intercompany payments and receipts which pass over the foreign exchanges. Fairly straightforward to operate, the main practical problem in bilateral netting is usually the decision about which currency to use for settlement. Netting reduces banking costs and increases central control of intercompany settlements. The reduced number and amount of payments yield savings in terms of buy/sell spreads in the spot and forward markets and reduced bank charges. Matching: Although netting and matching are terms which are frequently used interchangeably, there are distinctions. Netting is a term applied to potential flows within a group of companies whereas matching can be applied to both intra-group and to third-party balancing. Matching is a mechanism whereby a company matches its foreign currency inflows with its foreign currency outflows in respect of amount and approximate timing. Receipts in a particular currency are used to make payments in that currency thereby reducing the need for a group of companies to go through the foreign exchange markets to the unmatched portion of foreign currency cash flows. The prerequisite for a matching operation is a two-way cash flow in the same foreign currency within a group of companies; this gives rise to a potential for natural matching. This should be distinguished from parallel matching, in which the matching is achieved with receipt and payment in different currencies but these currencies are expected to move closely together, near enough in parallel. Both Netting and Matching presuppose that there are enabling Exchange Control regulations. For example, an MNC subsidiary in India cannot net its receivable(s) and payable(s) from/to its associated entities. Receivables have to be received separately and payables have to be paid separately. 191 CU IDOL SELF LEARNING MATERIAL (SLM)
Price Variation: Price variation involves increasing selling prices to counter the adverse effects of exchange rate change. This tactic raises the question as to why the company has not already raised prices if it is able to do so. In some countries, price increases are the only legally available tactic of exposure management. Let us now concentrate to price variation on intercompany trade. Transfer pricing is the term used to refer to the pricing of goods and services, which change hands within a group of companies. As an exposure management technique, transfer price variation refers to the arbitrary pricing of intercompany sales of goods and services at a higher or lower price than the fair price, arm’s length price. This fair price will be the market price if there is an existing market or, if there is not, the price which would be charged to a third-party customer. Taxation authorities, customs and excise departments and exchange control regulations in most countries require that the arm’s length pricing should be used. Asset and Liability Management: This technique can be used to manage balance sheet, income statement or cash flow exposures. Concentration on cash flow exposure makes economic sense but emphasis on pure translation exposure is misplaced. Hence our focus here is on asset liability management as a cash flow exposure management technique. In essence, asset and liability management can involve aggressive or defensive postures. In the aggressive attitude, the firm simply increases exposed cash inflows denominated in currencies expected to be strong or increases exposed cash outflows denominated in weak currencies. By contrast, the defensive approach involves matching cash inflows and outflows according to their currency of denomination, irrespective of whether they are in strong or weak currencies. 10.6 SUMMARY Hedging currency risk is through the use of hedging products, such as currency swaps, forward contracts and options Transaction risk is the risk of an exchange rate changing between the transaction date and the subsequent settlement date on an individual transaction. Economic risk Includes the longer-term effects of changes in exchange rates on the market value of a company (PV of future cash flows) Translation risk is changes in exchange rates affect the translated value of foreign assets and liabilities Economic risk is difficult to quantify but a favored strategy is to diversify internationally, in terms of sales, location of production facilities, raw materials and financing. 192 CU IDOL SELF LEARNING MATERIAL (SLM)
10.7 KEYWORDS FRA – Forward Rate Agreements Netting - Group companies merely settle inter affiliate indebtedness for the net amount owing Option - An option is a contract that allows (but doesn't require) an investor to buy or sell an underlying instrument Leading and Lagging - Leading and Lagging refer to adjustments at the time of payments in foreign currencies Swap - Agreement to exchange one currency for another at a specified exchange rate and date is termed as currency swap Cross Hedging – It means taking opposing position in two positively correlated currencies. 10.8 LEARNING ACTIVITY 1. ABC Technologic is expecting to receive a sum of US$ 4,00,000 after 3 months. The company decided to go for future contract to hedge against the risk. The standard size of future contract available in the market is $1000. As on date spot and futures $ contract are quoting at ` 44.00 &`Rs.45.00 respectively. Suppose after 3 months the company closes out its position futures are quoting at Rs.44.50 and spot rate is also quoting at Rs. 44.50. You are required to calculate effective realization for the company while selling the receivable. Also calculate how company has been benefitted by using the future option. ___________________________________________________________________________ ___________________________________________________________________________ 10.9 PRATICAL APPLICATIONS A Paper manufacturing company with import and export turnover of more than 100 crores was unaware about forex risk management systems and appointed the risk management team to manage their forex risk. They were banking with a PSU bank and faced operational challenges in their branch banking arrangements. Solution: Audit trail of the entire transaction and got the audio recording of the deal as well as e-mail communications to the client. The treasury was asked to check the deal details with their back office and after numerous calls and e-mails, the treasury agreed to honor the same rates that we had booked on forward rollovers. The treasury apologized for the lack of professionalism by their branch 193 CU IDOL SELF LEARNING MATERIAL (SLM)
10.10 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Explain the term Hedging? 2. What are Swap Options 3. Explain the usage of Offshore Banking Techniques 4. Define the term Social Trading 5. List out the various types of Hedging Techniques Long Questions 1. Briefly explain the Various types of Hedging Techniques utilised in Forex 2. Explain the Legal compliance and its Disclosures 3. Explain the opening and operating the forex account 4. Explain the concept and usage of Offshore Banking Techniques 5. Explain Swap options in detail. B. Multiple Choice Questions 194 1. The external methods of hedging transaction exposure does not include- a. forward contract hedge b. money market hedge c. cross hedging d. futures hedging 2. The cost of hedging through options includes- a. option premium b. interest on option premium till due date of the contract c. both (A) and (B) above d. Option premium and differences between option price and spot price. 3. Leading refers to- a. advancing of receivable b. advancing of payable c. advancing payments either receivables or payables d. advancing of receivables and delaying of payables 4. Exposed assets are those translated at- a. historical rate CU IDOL SELF LEARNING MATERIAL (SLM)
b. average rate c. current rate d. Current rate or average rate. 5. The participants in foreign exchange market are. __________ a. Investors b. Arbitrageurs c. Hedgers d. All of these Answers 1 – a 2 – c 3 – b 4 – a 5- d 10.11 REFERENCES OP Aggarwal, Trade and forex exchange, Himalaya Publications, 8th Edition Ranjit Singh, Forex Trading: RT Publications Shah Paresh, Forex Management, Wiley Ankit Gala and Jitendra Gala; Foreign Exchange and Forex Trading, Buzzing stock Publishing House Peters Jelle: Forex for Ambitious Beginners: Odyssean Publishing Sudhir Kochhar: Foreign Exchange Operations under FEMA: Bloomsbury Publishing (IN) 195 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT -11: PAYMENT TERMS IN FOREIGN EXCHANGE Structure 11.0 Learning Objectives 11.1 Introduction 11.2 Meaning of Commercial Invoice Letter 11.3 Credit Bills 11.4 Exchange Documents 11.5 Sources of Foreign Currency 11.6 Financing Formalities 11.6.1 Forex brokers 11.6.2 Social trading 11.7 Summary 11.8 Key words 11.9 Learning activity 11.10 Practical Applications 11.11 Unit End Questions 11.12 References 11.0 LEARNING OBJECTIVES After studying this unit, Students will be able to: Explain the Payment terms in Foreign Exchange Learn about Credit bills Discuss about Financing Formalities 11.1 INTRODUCTION Foreign exchange in trading activities is an unavoidable part of each country’s economy. The development of Information and Communication Technologies (ICT) has resulted in converting the whole World into a Global Village, where the distance is not a barrier for trading. In order to conquer global market and get sales against foreign competitors, the 196 CU IDOL SELF LEARNING MATERIAL (SLM)
exporters are required to offer attractive and convenient sales terms supported by apt payment methods. A suitable payment method should be selected circumspectly to reduce the payment risk while conforming the needs of the buyer since getting paid in full and punctually is the primary objective of each overseas sale. The Indian forex market is predominantly a transaction based market with the existence of underlying forex exposure generally being an essential requirement for market users. 11.2 MEANING OF COMMERCIAL INVOICE LETTER In international trade, a commercial invoice is an important document provided by the exporter to the importer. The buyer or the importer uses this invoice – and other shipping documents – to clear the shipment at customs in the country of import, a commercial invoice will provide all the important information regarding the shipment to buyers, freight forwarders, customs, agents, and banks. It is mandatory for all sea freight and air freight shipments. So, if an exporter ships airfreight via FedEx or DHL, they must provide a FedEx commercial invoice or a DHL commercial invoice. Notably, international commercial invoices do not show tax as international transactions may not be subject to local taxes. Hence, the exporter must take care to provide all the information in the correct format so that the importer does not face any trouble at the customs. Commercial Invoice Format Any commercial invoice for shipping & export should contain following essential details: Exporter’s company name, address, and contact number Importer’s company name, address, and contact details Buyer’s details if they are not essentially a consignee Mode of dispatch (whether by road, rail, air, or sea) Type of shipment (FCL, LCL, break bulk, etc) Vessel name and voyage number Names of the loading port, discharge port, and destination Invoice number and date Bill of lading number, Marine cover policy number, Letter of credit number Name of country of origin of the goods Destination of the goods 197 CU IDOL SELF LEARNING MATERIAL (SLM)
Terms/method of payment (optional) Apart from these details, the commercial invoice must also have the product details. This would include the description, quantity, HS code/HSN Code, unit type, price, and currency. Do not overlook to mention the terms of trade or the agreement between the two trading parties. In the end, provide the name, date, and signature of the authorized company representative. Fig 11.1 Com mercial Invoice 198 CU IDOL SELF LEARNING MATERIAL (SLM)
11.3 CREDIT BILLS Letter Of Credit Letter of credit is a type of payment term opted by importers and exporters. Letters of credit (LCs) are one of the most secure instruments accessible to international traders. An LC is a commitment by a bank on behalf of the buyer that payment will be made to the exporter, provided that the terms and conditions stated in the LC have been met, as confirmed through the presentation of all required documents. In other words, we can explain that a Letter of Credit is an undertaking issued by a Bank, at the request of an importer, affirming the payment to the exporter on presentation of complying documents as stated in the LC. It is an assurance from the bank that a buyer's payment to a seller will be received on time and for the correct amount and thus makes elimination of possible risks. If the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. Due to the nature of international dealings, including factors such as distance, contrasting laws in each country, and difficulty in knowing reliability of each party personally, the use of letters of credit has become a vital aspect of international trade. A letter of credit is typically a negotiable instrument; the issuing bank pays the beneficiary or any bank nominated by the beneficiary. If a letter of credit is transferrable, the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw. Banks typically require a pledge of securities or cash as collateral for issuing a letter of credit. Banks also collect a fee for service, typically a percentage of the size of the letter of credit. An LC is useful when reliable credit information about a foreign buyer is hard to get, but the exporter is satisfied with the creditworthiness of the buyer’s foreign bank. An LC also secures the buyer because no payment obligation arises until the goods have been shipped or delivered as promised or guaranteed. 11.4 EXCHANGE DOCUMENTS A bill of exchange is a written order used primarily in international trade that binds one party to pay a fixed sum of money to another party on demand or at a predetermined date. Bills of 199 CU IDOL SELF LEARNING MATERIAL (SLM)
exchange are similar to checks and promissory notes—they can be drawn by individuals or banks and are generally transferable by endorsements. Working Of a Bills Of Exchange A bill of exchange transaction can involve up to three parties. The drawee is the party that pays the sum specified by the bill of exchange. The payee is the one who receives that sum. The drawer is the party that obliges the drawee to pay the payee. The drawer and the payee are the same entity unless the drawer transfers the bill of exchange to a third-party payee. Unlike a check, however, a bill of exchange is a written document outlining a debtor's indebtedness to a creditor. It's frequently used in international trade to pay for goods or services. While a bill of exchange is not a contract itself, the involved parties can use it to fulfil the terms of a contract. It can specify that payment is due on demand or at a specified future date. It's often extended with credit terms, such as 90 days. As well, a bill of exchange must be accepted by the drawee to be valid. Bills of exchange generally do not pay interest, making them in essence post-dated checks. They may accrue interest if not paid by a certain date, however, in which case the rate must be specified on the instrument. They can, conversely, be transferred at a discount before the date specified for payment. A bill of exchange must clearly detail the amount of money, the date, and the parties involved including the drawer and drawee. EXAMPLE: Let's say Company ABC purchases auto parts from Car Supply XYZ for Rs 25,00,000. Car Supply XYZ draws a bill of exchange, becoming the drawer and payee in this case. The bill of exchange stipulates that Company ABC will pay Car Supply XYZ Rs 25,00,000 in 90 days. Company ABC becomes the drawee and accepts the bill of exchange and the goods are shipped. In 90 days, Car Supply XYZ will present the bill of exchange to Company ABC for payment. The bill of exchange was an acknowledgment created by Car Supply XYZ, which was also the creditor in this case, to show the indebtedness of Company ABC, the debtor. 11.5 SOURCES OF FOREIGN CURRENCY Major sources for raising foreign currency finances are as follows: 200 CU IDOL SELF LEARNING MATERIAL (SLM)
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