Theme: Overview of International FinanceChapter 1 (Overview of International Trade & Finance srnational trade: Global markets have opened up and trade and financial services are moving freely from ‘one country to other and banking services are becoming more responsive to such rapid changes. Inputs and accessories can be sourced from country A, assembling and manufacturing can be done in country B, Seller may be in Country C and the ultimate user or the consignee can be in country D and the financing institution can be in Country E, This is become possible today since borders are not the barriers for movement of goods or finance or manpower. If the corporate has professional edge, they can take up any project abroad whereby they are able to expand their market presence and also exposing them to the latest global technology. Further, import of capital goods and technology is also made simple with the assistance of the finance institution, which provides wholesale banking solutions, Due to the development of *Off-shore financial markets’, borrower can be in any country and the lending institution can be in the third country. Lending institutions are able to offer credit facilities at international interest rates based on LIBOR in any currency. Role of Banks: Banks are offering variety of products under wholesale banking to their clients, starting from assisting their client financially for importing accessories or raw materials from any country and funding their working capital requirements for their manufacturing activities and extending credit against their receivables. Under wholesale banking, benks are also offering risk management solutions to corporate clients to mitigate credit risk pr tection against the default of the buyer, political risk cover for the country exposure and curency risk management against the currency exposure. For example, if a client wants to expand his produetion capacity and enlarge his client’s list to different countries he may require following financial solutions from their bank: ‘+ For expansion of their production / manufacturing capacity they may ike to avail Joar facilities to import / buy capital equipments and modernization expenses. Credit facilities can be of medium or long-term requirements and it can be either in home currency or in foreign curreney. Their bankers locally or through theit foreign correspondent banks abroad can arrange foreign currency loan at a competitive intemational interest rates. © For importing equipments or accessories, bank can establish letter of credit or standby credit or guarantees or bankers acceplance facility in favour of the overseas suppliers. ® For working capital expenses to meet any export obligations, bank can sanction export credit facilities either by themselves or through any of the global credit agencies like Exim Bank. © Once manufacturing activities are over and sales staris banks can discount clients receivable by offering receivable management solutions. FMChapter 1 Global Financial Environment ‘This chapter sets the backdrop for exploring multinational business finance. Its main purpose is to provide a perspective on global financial markets and the intemational monetary system which is supposed to define and enforce the rules of the game in the arena of international finance. The focus will be on the substantive conceptual issues rather than on facts and figures which are of transient importance. At the end of the chapter you will have learnt: The distinguishing features of international finance. '® The essential concepts of Balance of Payments and their interpretation. 58 What are global financial markets? What are “offshore” markets? &, Evolution and present status of the international monetary arrangements including the IME, EMS and EMU, SDRs and intemational reserves. 1.1 & THE CHALLENGE OF INTERNATIONAL FINANCE Ihe decade of 1990s can be characterised as the “Globalisation Decade”. Around the world, the process of dismantling the barriers to intemational trade and capital flows which had begun in early 1980s accelerated in the 1990s and reached its culmination during the closing years of the last decade of the 20th century. The globalisation process has accelerated during the starting years of the 21* century. Even developing countries like India, which for a long time followed an inward-looking development strategy concentrating on import substitution have, in recent years, recognised the vital necessity of participating vigorously in international exchange of goods, services and capital. The 1980s witnessed a significant shift in policy towards a more open economy, considerable liberalisation of imports and a concerted effort to boost exports. Starting in 1991, the decade of 1990s ushered in further policy initiatives aimed at integrating the Indian economy with the intemnational economy. The policy stance in the new millennium also stresses more openness and networking with the global economy.4 International Finance ‘Quantitative restrictions on imports are being phased out as part of WTO commitments, and import duties are being lowered. Foreign direct and portfolio investments are on the rise. A unified market determined exchange rate, current account convertibility and a slow but definite trend in the direction of liberalising the capital account have opened up the Indian economy to a great extent. In keeping with the commitments made to WTO, all quantitative restrictions on imports were abolished at the end of March 2001. Restrictions on accessing foreign capital markets have been considerably liberalized and further liberalisation is expected to continue. Similarly barriers on inward and outward foreign direct investment as well as portfolio investment by Foreign Institutional Investors in India have been significantly liberalised. Indian business giants acquiring foreign companies has begun and is expected to continue. Further lowering of tariff barriers, greater access to foreign capital, relaxation of rules governing foreign portfolio and direct investment and finally capital account convertibility are certainly on the reform agenda of the Indian government. Freedom from controls has meant enormous widening of opportunities. For the finance manager it means a much wider menu of funding options, investment vehicles, cost reduction and return enhancement through innovative structured financing and investment vehicles and many other exciting prospects to exercise his or her ingenuity. However, freedom and maturity also imply loss of innocence and simplicity. There was a time when most finance managers in India did not have to worry about gyrations in exchange rates, ups and downs in interest rates, twists and shifts of the yield curve, whether bulls or bears were on the rampage on Wall Street, whether Russia was being buried under a mountain of debt and what Standard & Poor thought of the Indian economy. Today, such complacency would be a sure recipe for disaster. As we will discover in the rest of the book, almost every firm is today exposed to fluctuations in the financial markets not only at home but also abroad. For some firms, the exposure is direct and obvious; for others it is indirect via effects on their customers, suppliers and competitors. Integration of financial markets and mind boggling advances in communications and information technology means no economy is an island unto itself. Economic events, government actions and investor sentiments in any part of the world spread throughout the global financial markets extremely rapidly. The fallout of the Asian crisis and the upheavals following the Russian collapse have brought home this lesson. In fact it has led many experts and policy makers to question the desirability of a laissez faire global financial system. ‘Thus, with increasing opportunities has come a quantum leap in financial risks, The purpose of this book is to equip you with conceptual tools and basic familiarity with markets and institutions which will enable you to analyse the opportunities offered by the global financial markets and their associated risks. Every finance manager today must acquire this kasic toolkit to successfully perform his or her function and add shareholder value. A brief outline of the rest of the book is as follows. The rest of this chapter provides a broad perspective on the global financial markets and the international monetary system. Chapter 2 exposits the basic exchange rate economics. Chapter 3 is devoted to understanding of the workings of the foreign exchange market. Chapter 4 is an introduction to basic currency derivatives, viz. currency futures and simple options. In Chapter 5 we address the issue of how to define and measure financial exposure and risk and whether and why firms should actively manage such risks. Chapter 6 takes you through the process and techniques of managing PaGlobal Financial Environment 5 currency exposure. Chapter 7 deals with cash management in the multinational context as also trade finance. Chapter 8 covers long-term financing in global markets. Chapter 9 provides some tools for appraising foreign direct investment projects. Chapter 10, provides an introductory treatment of financial swaps. The last chapter, Chapter 11 covers some innovative products like Forward Rate Agreement, Interest Rate Futures and Interest Rate Options. ‘The emphasis is always on providing a clear understanding of the financial characteristics of products and techniques. The institutional aspects are important but subject to frequent changes and hence difficult to deal with adequately in a book of this nature. Last, but not the east, the book does not enter into the intricacies of accounting and taxation, a task best left to specialist works on those subjects. 1.2 THE FINANCE FUNCTION IN‘A GLOBAL CONTEXT - ‘The finance function in a typical non-financial firm consists of two main tasks, viz. treasury on the one hand and accounting and control on the other (see Exhibit 1.1). Needless to say, the treasurer and the controller do not function in watertight compartments. There is a continuous exchange of information and mutual consultations. In many firms, both the tasks may in fact ‘be headed by a single person without any formal separation of the two responsibilities. In what way is the finance function different in a multinational context? The basic tasks of both the treasurer and the controller remain the same as in the case of a purely domestic firm; the difference isin terms of available choices and the attendant risks. Here are the key differences: Exhibit 1,1. The Finance Function [TREASURER CONTROLLER - f | i | nancial. ‘Financial and. ce eannat || Fe | E regener Analysis” ‘ ‘Accounting C : =] [TaxPlanning” |[ Budget ee ee ‘Acquisition “)) Decisions “| | tanagement ‘and Control ' q Terapia] | pow wowomet || re | Franorg, |] Managment] | Momaton |) Racoon 1. The firm must deal with multiple currencies. It must make or receive payments for goods and services in currencies other than its “home currency”, raise financing in foreign currencies, carry financial assets and liabilities denominated in foreign currencies and so forth. Thus it must acquire the expertise to deal in the forex market and lear to manage the uncertainty created by fluctuations in exchange rates. 2 rus6 Intemational Finance 2. A treasurer looking for long or short-term funding has a much richer menu of options to choose from when he or she is operating in a multinational context. Different markets— national or offshore—different instruments, different currencies and a much wider base of investors to tap. Thus the funding decision acquires additional dimensions—which market, which currency, which form of funding—that are absent when the orientation is purely domestic. 3. Similarly, a treasurer looking for outleis to park surplus funds has a wider menu of options in terms of markets, instruments and currencies. 4, Bach cross-border funding and investment decision exposes the firm to two new risks, viz. exchange rate risk and political risk. The latter denotes the unforeseen impact on the firm, of events such as changes in foreign tax laws, laws pertaining to interest, dividend. and other payments to non-residents, risks of nationalisation and expropriation. These are over and above all the other risks associated with these decisions, viz. interest rate risks, credit risks. 5. Cross-border financing and investment also obliges a firm to acquire relevant expertise pertaining to accounting practices, standards and tax laws applicable in foreign jurisdictions, ‘To summarise, managing the finance function in a multinational context involves wider opportunities, more varied risks, multiplicity of regulatory environments and, as a consequence, increased complexity in decision making. 1,3 = RECENT CHANGES IN GLOBAL FINANCIAL MARKETS The decade of 1980s witnessed unprecedented changes in financial markets around the world. ‘The seeds of these changes were however sown in the 1960s with the emergence of euromarkets, which were a sort of parallel money markets, virtually free from any regulation, This led to intemnationalisation of the banking business. These markets grew vigorously during the seventies and pioneered a number of innovative funding techniques. The outstanding feature of the changes during the eighties was integration. The boundaries between national markets as well as those between national and offshore markets are rapidly ‘becoming blurred leading to the emergence of a global unified financial market. The financial system has grown much faster than real output since the late 1970s!. Banks in major industrialised countries increased their presence in each other's countries considerably”. Major national markets such as the US, Europe and Japan, are being tapped by non-resident borrowers, onan extensive scale. Non-resident investment banks are allowed access to national bond and stock markets. The integrative forces at work through the 1960s have more or less obliterated the distinction between national and intemational financial markets’. Today, both the potential borrower and the potential investor have a wide range of choice of markets. 1 The stocks of eurocurrency bank Joans and bonds have increased at the rate of 14% and 21% per annum respectively since 1975. See Anagol (1990). 2 Even in a market as large as the US, foreign banks hold about a quarter ofthe banking assets, > This does not mean that national markets have all become alike in terms of the kinds of instruments available, market practices and regulatory proceshures, %Global Financial Environment zi In addition to the geographical integration across markets, there has been a sirong trend towards functional unification across the various types of financial institutions within individual markets. The traditional segmentation between commercial banking, investment banking, consumer finance, etc. is fast disappearing with the result that nowadays “everybody does everything”. Universal banking institutions /bank holding companies provide worldwide, a wide range of financial services including traditional commercial banking. The driving forces behind this spatial and functional integration were first, liberalisation with regard to cross-border financial transactions and, second, deregulation within the financial systems of the major industrial nations. The most significant liberalisation measure was the lifting of exchange controls in France, UK and Japan. (The markets in US, Germany, Switzerland, Holland were already free from most of the exchange controls.) Withholding taxes on interest paid to non-residents were removed, domestic financial markets were opened up to foreign borrowers and domestic borrowers were allowed access to foreign financial markets. Thus in the portfolios of investors around the world, assets denominated in various currencies became more nearly substitutable—investors could optimise their portfolios taking into consideration their estimates of returns, risks and their own risk preferences. On the other hand, borrowers could optimise their liability portfolios in the light of their estimates of funding costs, interest rate and exchange rate risks and their risk preferences. Deregulation involved action on two fronts. One was eliminating the segmentation of the markets for financial services with specialised institutions catering exclusively to a particular segment and measures designed to foster greater competition such as abolition of fixed brokerage fees, breaking up bank cartels and so forth. The other was permitting foreign financial institutions to enter the national markets and compete on an equal footing with the domestic institutions in offering financial services to borrowers and investors. The fever of liberalisation and deregulation has also swept the various national stock markets. ‘This is the least integrated segment of financial markets though in recent years the number of non-resident firms being listed on major stock exchanges like New York and London has increased significantly. Liberalisation and deregulation have led to a significant increase in competition within the financial services industry. Spreads on loans, underwriting commissions and fees of various kinds have become rather thin. Another factor responsible for this is the tendency on the part of prime borrowers to approach the investors directly by issuing their own primary securities thus depriving the banks of their role and profits as intermediaries. This is a part of the overall trend towards securitisation and disintermediation. The attainment of the Economic and Monetary Union (EMU) and the birth of Euro in the closing years of the decade of 1990s have led to the emergence of a very large capital market which has the potential to rival the US financial markets as provider of capital to firms and governments around the world. In recent months there has been considerable discussion about the possibility of Euro replacing the US dollar as the key currency in global financial markets. The pace of financial innovation has also accelerated during the last ten to fifteen years. The motive force behind innovations like options, swaps, futures and their innumerable permutations and combinations comes both from the demand side and the supply side. On the8 International Finance onehand, with the floating of exchange rates in 1973. new factor was introduced in intemational finance, exchange rate volatility and the substantially higher interest rate volatility. These witnessed during the 1980s led to demand for newer kinds of risk management products to minimise if not eliminate totally exchange rate and interest rate risks. On the supply side, the traditional sources of income for commercial banks and investment banks such as interest, commissions, fees, etc,,.were subjected toa squeeze. This led to their offering complex, innovative deals and products, often tailored to the specific needs of a borrower or an investor, in the hope of skimming off fat fees before the competitors wised up to the fact and started offering similar products. Thus there is a race on to come up with increasingly complex and often esoteric products which, itis sometimes said, the bankers themselves do not fully understand. The innovation mania has been made possible and sustained by the tremendous advances in telecommunications and computing technology. Financial markets even in developing countries like India have started trading these derivative instruments and many exotic combinations thereof. Liberalisation and deregulation of financial markets is an ongoing process. From time to time events and circumstances give rise to calls for re-imposition of some controls and bairiers to cross-border capital movements. Some governments resort to such measures to contain or prevent a crisis. Many economists have proposed taxation of certain capital account fransactions—particularly short-term movements of funds—to “throw sand in the excessively oiled machinery of global capital markets”. The quality and rigour of Banking supervision in many developing countries needs considerable improvement. In the Westem hemisphere, US and most of Europe have more or less free financial markets. Japan started the process around mid-eighties and most of the barriers have been dismantled ‘though some restrictions still remain. In other parts of the world, countries like Singapore and Hong Kong already have very active and quite free financial markets. Australia has taken great strides in the same direction. Eastern Europe and the third world haye begun their economic reforms including freeing their financial sectors. Recent years have seen a surge in portfolio investments by institutional investors in developed countries, in the emerging capital markets, in Eastern Europe and Asia. A large number of companies from developing countries have successfully tapped domestic markets of developed countries as well as offshore markets to raise equity and debt finance. The explosive pace of deregulation and innovation has given rise to serious concerns about the viability and stability of the system. Events such as the LDC debt crisis and the 1987 stock ‘market crash in the 1980s (and the speed with which it spread around the world’s major capital markets), the East Asian currency crisis, and the events following the Russian debacle including the fall of LTCM a giant hedge fund in the 1990s have underscored the need to redesign the regulatory and control apparatus. This will be necessary to protect investors’ interests, make the system less vulnerable to shocks originating in the real economy, will enable localisation and containment of crises when they do occur, without unduly stifling competition and making the markets less efficient in their role as optimal allocators of financial resources. Increasing interdependence implies convergence of business cycles and hence less resilience in the global ‘economy. Disturbances following a local financial crisis tend to spread throughout the global system at the “speed of thought” making the policy makers’ task extremely difficult. 2ee Global Financial Environment 9 International bodies such as the IMF have already begun drawing up blueprints for a new architecture for the global financial system. Extensive debates will follow among economists, finance experts and policy makers before the blueprints are translated into new structures + Taxonomy of Financial Markets Financial markets can be classified in various ways. The main division we will follow here is that between domestic or on-shore markets on the one hand and off-shore markets on the other. Domestic markets are the traditional national markets subject to the regulatory jurisdiction of the country’s monetary and securities markets authorities, trading assets denominated in the country’s currency. Thus the markets for government and corporate debt, bank loans, the stock market, etc. in India is the Indian domestic market. Similar markets exist in most countries though many of them in developing and emerging market economies are quite underdeveloped In many countries non-resident entities are allowed to raise funds in the country’s domestic market which gives the market an “international” character. Thus an Indian company (e.g. Reliance Industries) can issue bonds in the US bond market and a Japanese company can list itself on London stock exchange. The main feature of these markets is that they are generally very closely monitored and regulated by the country's central bank, finance ministry and securities authority like the Securities Exchange Commission in the US. Ofi-shore or external markets are marketsin which assets denominated in a particular currency are traded, but the markeis are located outside the geographical boundaries of the country of that currency’. Thusa bank located in London or Pariscan accept time deposit denominated in US dollars from another bank or corporation—an “off-shore” dollar deposit. A bank located in Paris might extend a loan denominated in British pound sterling to an Australian firm—an “off-shore” sterling loan. An Indian company might issue in London, bonds denominated in US. dollars—an “off-shore” US dollar bond. The main characteristic of these off-shore markets is that they are not subject to many of the monitoring and regulatory provisions of the authorities of their country of residence nor of the country of the currency in which the asset is denominated. For instance, a bank in the US accepting a deposit would have to meet the reserve requirements laid down by the Federal Reserve and also meet the cost of deposit insurance; the London branch of thesame bank accepting a dollar deposit is not subjectto these requirements. An Indian company making a US dollar bond issue in the US would be subject to a number of disclosure, registration and other regulations laid down by the SECS; dollar bonds issued in London face no such restrictions and the firm may find this market more accessible. Since both investors and issuers are generally free to access both the domestic and off-shore markets in a currency, it is to be expected that the two segments must be closely tied together. In particular, interest rates in the two segments cannot differ significantly. There will be some differences due to the fact that one segment is more rigorously regulated (as also protected against systemic disasters), but unless the authorities impose restrictions on funds flow across the two segments, the differences will be very small. We will examine this in greater detail below. + As we shall see shortly below, this is not strictly true 5Of course, in many domestic markets, there are “private placement” segments which are not so tightly regulated as a “public” offering 210 _tntermational Finance ‘The eurocurrency market or simply the euromarket was the first truly off-shore market to emerge during the early post-war years. It blossomed into a global financial marketplace by the end of 1980s. A brief look at its evolution and structure will enable us to understand how off-shore markets function. With the spread of such markets to locations outside Europe, and the arrival of the pan-European currency named “Euro”, the designation “eurocurrency markets” became inappropriate and inconvenient. A US dollar deposit with a bank in London used to be called a “eurodollar” deposit. What do you call a deposit denominated in Euro with a bank in Singapore? The designation “euroEuro” deposit would be rather cumbersome. A more appropriate and comprehensive designation is “off-shore” markets. Some off-shore banking markets are located in the so-called tax havens such as Bahamas, Cayman islands and so forth which provide stable political environment, excellent communications infrastructure, minimal regulation and above all low taxes. Asa response to the competitive threat posed by eurobanks, the US government permitted US banks to create International Banking Facilities which are a kind of “on-shore-off-shore” markets. They are subsidiaries of US banks, located within United States but doing business exclusively with non-resident entities and not subject to the domestic regulations. Thus they are also a part of the off-shore US dollar market. Such “or-shore-off-shore” banking markets also exist in other countries such as Japan. * Offshore Financial Markets: What are They? Prior to 1980 Eurocurrencies market was the only truly international financial market of any significance. It is mainly an interbank market trading in time deposits and various debt instruments. A “Eurocurrency Deposit” isa deposit in the relevant currency with a bank outside the home country of that currency. Thus, a US dollar deposit with a bank in London is a Eurodollar deposit, a Japanese yen deposit with a bank in New York is a Euroyen deposit. Note that what matters is the location of the bank—neither the ownership of the bank nor ‘ownership of the deposit. Thus a dollar deposit belonging to an American company held with the Paris branch of an American bank is still a Eurodollar deposit. Similarly a Eurodollar Loan is a dollar loan made by a bank outside the US to a customer or another bank. The prefix “Euro” isnow outdated since such deposits and loans are regularly traded outside Europe, e.g. in Singapore and Hong Kong (These are sometimes called Asian dollar markets). That is the reason we have used the more inclusive designation “Off-shore markets”. While London continues to be the main off-shore centre, for tax reasons, loans negotiated in London are often booked in taxchaven centres such as Grand Cayman and Nassau [See Stigum (1990)]. It must be clearly understood that every off-shore deposit has ils counterpart in a deposit in the home country of the relevant currency. This can be understood by examining a typical sequence of transactions which leads to the creation of off-shore deposits. Suppose Microsoft wishes to place USD 25 million in a 91-day deposit. It obtains rate quotations from various banks in the US and in London. It finds the rate offered by Barclays bank in London, 8% p.., ‘most attractive. It instructs CITI bank New York to transfer USD 25 million to Barclays. CITT informs Barclays London and asks where the funds should be credited. Barclays London ‘maintains an account with Chase New York. CITI debits Microsoft’s account and credits Barclays account with Chase, This transfer would take place via an interbank clearing system such as »Global Financial Environment " CHIPS* in the USA. Barclays creates a deposit account in the name of Microsoft in London and credits it with USD 25 million, A eurodollar or off-shore dollar deposit has been created but “physically” the dollars have not left the USA. At maturity 91 days later, Barclays will calculate interest payable as, 25000000 x 0.08 x (91/360) = $505555.56 and credit to Microsoft's deposit account. In these off-shore markets the day count convention for interest calculations is “actual /360", ie. fraction of an year is calculated by taking actual number of days in the deposit or loan and assuming that an year has 360 days”. Suppose Microsoft wishes to invest the money for a further period of 91 days. This time it finds that Commerzbank Frankfurt is offering the best rate. It instructs Barclays London to transfer the money to Commerzbank. Commerzbank maintains an account with Bank of America, New York. Barclays instructs Chase to debit its account and transfer the funds to the account of Commerzbank with BankAm. So the process goes on. Of course, Barclays is not going to let the funds lie idle in its Chase account for 91 days. It might keep some level of reserves and try and find an eligible borrower. Suppose on the same day that Microsoft makes its initial deposit, a French firm wishes to obtain a 90-day loan of USD 20 million and finds that Barclays rate is the cheapest. It draws the loan and instructs Barclays to transfer the funds to its bank, BNP, Paris. BNP has an account with Bank of America in Los Angeles. Barclays instructs Chase to transfer the funds to BNP’s account with Bank of America. BNP creates an off-shore or eurodollar deposit in the name of the French firm. Another eurodeposit has been created. You can then see that BNP can and probably would repeat the process which will lead to creation of further eurodollar deposits. Justas in the case ofa fractional reserve domestic banking system, eurobanks can create multiple deposits based on an initial injection of funds into the system®. But the funds never leave the home country of the currency in question. Over the years, these markets have evolved a variety of instruments other than time deposits and short-term loans, e.g. Certificates of Deposit (CDs), Euro Commercial Paper (ECP), medium to long term floating rate loans, Eurobonds? , Floating Rate Notes (FRNs) and Euro Medium Term Noles (EMTNs). We will study these instruments later in this book ‘As mentioned above, the key difference between off-shore markets and their domestic counterparts is one of regulation. For instance, Eurobanks are free from regulatory provisions such as cash reserve ratio", deposit insurance, ete. which effectively reduces their cost of funds. Eurobonds are free from rating! and disclosure requirements applicable to many domestic © “CHIPS” stands for Clearing House Interbank Payments System, Similar clearing systems for netting out interbank transfers exist in other countries. 7 This is true for most currencies. The major exceptions are British pound, Irish punt and Australian dollar. For these currencies the day count convention is “actual/365", i. an year is deemed to have 365 days. § Tfat any point in the chain, the borrower wishes the loan proceeds to be transferred to an account in the US, the deposit expansion process will come toa halt. ‘In keeping with the definition of eurodeposits, a dollar commercial paper or @ dollar bond issued say in London become, respectively, eurodollar commercial paper and eurodollar bond. *© That is not to say that eurobanks will not keep any reserves: they will be guided by their own prudential norms, There is no statutory requirement. ™ Once again, rating is not mandatory but having a good rating would enable the issuer to get better terms2 Intemational Finance issues a5 well as registration with securities exchange authorities. This feature makes it an attractive source of funding for many borrowers and a preferred investment vehicle for some investors compared to a bond issue in the respective domestic markets. * Evolution of Offshore Markets Eurocurrency markets, specifically the eurodollar market, is said to have originated with the Russian authorities wishing to have dollar-denominated deposits outside the jurisdiction of the US government. Banks in Britain and France obliged and the eurodollar market was bom. ‘The subsequent enormous growth of the eurodollar market can be attributed to the following, factors: 1. Throughout the 1960s and 1970s American banks and other depository institutions had to observe ceilings on the rate of interest they could pay on deposits!. These restrictions did not apply to banks outside the US, and a number of American banks began accepting, dollar deposits in their foreign branches. The dollars so obtained were often reinvested in the US. Most of these restrictions had been lifted by mid-1970s. 2, Asmentioned above, reserve requirements and deposit insurance implied higher effective cost of funds for US domestic deposits. Since branches of US banks outside the US did not have to observe these restrictions, they could offer slightly higher rates to depositors and slightly lower rates to borrowers. Hence it was attractive to accept dollar deposits in foreign branches rather than at home. 3. Due to the importance of the dollar as a vehicle currency in international trade and finance, many European corporations have cash flows in dollars and hence temporary dollar surpluses and the need to make payments in dollars. Hence they wished to have deposits denominated in dollars. Convenience of the same time zone as well as their greater familiarity with European banks, inclined these companies to prefer European banks, a choice made more aitractive by the higher rates offered by Eurobanks. 4. These factors were reinforced by demand for Eurodollar loans by non-US entities and by US multinationals to finance their foreign operations. During the nineteen sixties as the US balance of payments deteriorated, the government imposed a series of restrictions which made it difficult and /or more expensive for foreign entities to borrow in the US, ‘The voluntary foreign credit restraints of 1963, followed by mandatory controls on foreign lending and the interest equalisation tax (a tax on interest earned by US residents from. foreigners) induced channelling of funds through the Eurodollar markets where these regulations did not apply. The reasons behind the emergence and robust growth of the eurodollar markets can be summarised in one word, viz. regulations. For both borrowers and lenders, the various restrictions imposed by the US government induced them to evolve Enrodollar deposits and loans. Added to this are the considerations mentioned above, viz., the ability of eurobaniks to 1 The most important of these was the regulation Q which specified a maximum rate of interest payable on savings deposits, "8 jna similar vein, the restriction imposed by the British government on British banks borrowing at home to finance third country trade also played a small role. 2 FucaGlobal Financial Environment 13 offer better rates both to depositors and borrowers (which again can be attributed to existence of regulations) and the convenience of dealing with a bank closer to home who is familiar with the business culture and practices in Europe". Another contributing factor was the restrictions imposed by UK authorities sometime in the fifties which prevented UK banks from providing trade finance in sterling, ‘The emergence of offshore markets in currencies other than the dollar can also be attributed. to similar considerations though in these cases better rates and familiarity perhaps played a more important role. As exchange controls were eased and offshore banking was encouraged by authorities, offshore markets developed in many other centres including the Far East. As mentioned above, the emergence of Euro as a possible vehicle currency and a substitute for dollar will lead to emergence of strong off-shore markets in Euro. It is difficult to obtain precise estimates of the size of the off-shore market, particularly net figures, ie. excluding interbank placement of funds. Exhibit 1.2 below provides some recent data on the outstanding volume of external loans and deposits of reporting banks taken from BIS. These data include loans made to and deposits taken from all non-residents by banks in BIS reporting countries and thus include the so-called euroloans and deposits. Exhibit 1.2 External Loans and Deposits of Reporting Banks (Billions of US Dollars) ‘Loans Deposits 2005 December 152018 172133 2006 December 189987 2104.9 2007 September 29295.0 256545 ‘Source: Quarterly Review: Intemational Banking and Financial Market Developments, Bank for Intemational Settements, March 2008. 1.4 2 INTEREST RATES IN-THE GLOBAL MONEY MARKETS. The purpose of this section is to examine the linkages between interest rates in the domestic and off-shore markets on the one hand and, on the other hand, between interest rates for different currencies in the offshore market. The spectrum of interest rates existing in an economy at any point of timeis the result of the complex interaction between several forces. Exhibit 1.3 provides a schematic picture of interest rate determination. ‘As seen in the figure, the short-term money market rates in a domestic money market are linked to the so-called risk-free nominal interest rate, usually the yield offered by short-term government securities like treasury bills. In the Eurocurrency market, which is primarily an interbank deposit market, the benchmark is provided by the interbank borrowing and lending jn the case of banking centres in "tax haven’ locations like Bahamas, Cayman islands, etc. low or non- existent corporate taxation was also a factor. Of course many of these operations were only “name plate” ‘operations like Liberian or Panmaian shipping companies. 38“ International Finance: rates. The most widely known benchmark is the LONDON INTER-BANK OFFER RATE abbreviated LIBOR. This is an index of the rate which a “first class” bank in London will charge another first class bank for a short-term Joan. Note that LIBOR is not necessarily the rate charged by any particular bank; it is only an indicator of demand-supply conditions in the interbank deposit market in London’. Another rate often referred to is the LIBID-London Inter-Bank Bid Rate, the rate which a bank is willing to pay for deposits accepted from another bank'®, Obviously, LIBOR would vary according to the term of the underlying deposit. Thus financial press nommally provides quotations for 3- and 6-month LIBORS. In the market, deposits range in maturity from one night up to one year. LIBOR also varies according to the currency in which the loan or deposit is denominated. We will discuss below the link between LIBORs for different currencies. Exhibit 1.3 Determinants of Interest Rates Ezcromy | [Woney | [ResiOapa] [ Byectatone Rain” || Growth Grom | | teu Datu Rak Expected Feauies atl iaion Rea Rate Nomina Roe Rate CTeiisee | [Eonar rt | se Rates | 00, cP ete. 75 In many loan agreements as also in instruments like Floating Rate Notes (FRNS) the rate to be paid by the borrower is stated as (LIBOR + a spread). In such cases, the agreement clearly spells out how LIBOR is to be determined on the rate resetting date. For instance, it might say that on the resetting date, rate quotations will be obtained from 12 major banks in London at 11.00 a.m. London time, the two highest and the two lowest will be discarded and the arithmetic average of the remaining eight will become “the LIBOR” for rate setting purposes. 1 LIMEAN is the average of LIBOR and LIBID. reaGlobal Financial Environment 5 Exhibit 1.4 gives 6-month LIBORs for various currencies. Exhibit 1.4. 3-Month and 6-Month LIBORs (End April 2008 in % per annum) Currency ‘Month LIBOR 6-Month LIBOR US Dollar 2.85 2.96 Euro 486 488 Japanese Yen 92 0.98 Pound Sterting 584 5.84 ‘Swiss Frane 281 292 ‘Source: wrw.economagic.com Exhibit 1.5 Short-Term Rates—UK Exhibit 1.6 Short-Term Rates—US (End April 2008; % per annum) (End April 2008 % per annum) 3-Month Treasury Bill Rate: 4.90 Federal Funds: 2.28 3-Month CD Rate: 4.19 3-MonthTreasury Bill: 1.73 Interbank Rate: 5.80 Month CP: 2.00 Prime Rate: 5.24 90-Day CD Rate: 2.66 ‘Source: For US rates Resources for Economists; for UK rates Bank of England Exhibits 1.5 and 1.6 present selected short-term interest rates for the United Kingdom and the United States money markets respectively. Let usnow discuss the relationship between interest rates in the domesticand euro segments of the money market. Exhibit 1.7 provides some data on US dollar month comunercial paper and certificates of deposit interest rates in the domestic market and the 3-month LIBOR in the off-shore segment. While not strictly comparable, they serve to bring out the close connection between the two markets. As can be seen the rates are close and generally move together. This is not surprising since as said above, arbitrage by borrowers and investors with access to both the markets should serve to keep the rates close together. Consider this exampl In the US domestic markets 90-day CD (Certificates of Deposit) rates are ruling at 5.5%. There is a reserve requirement of 6% against funds raised with CDs and a deposit insurance premium of 0.04%. This means a US bank can raise funds in the US domestic market at an effective cost of {(6.50 + 0.04)/(1 -0.06)}% = 5.90% Suppose, the bid rate for 90-day US dollar deposits in London is 7%. Banks with access to the US domestic money market can raise funds there and place them in London for an arbitrage profit of 1.10%. In doing so they would bid up the CD rates in the US domestic market and put downward pressure on 90-day US dollar LIBID bringing the two rates close together so that the arbitrage opportunity disappears. Why are the rates not identical? Two explanations have been offered. The first emphasizes the demand side, viz, differences in investors’ (depositors’) perception of risks associated with as16 Intemational Finance different banks. Suppose, a British bank in London accepts a US dollar deposit from a US resident. If it goes bankrupt, will the Bank of England rescue its off-shore business and will the US. resident get his deposit back? If eurobanks are perceived to be more risky—who will bail them out if they get into trouble—depositors would demand a risk premium which would force eurobanks to pay somewhat higher deposit rates. On the other hand, if depositors who are not residents of the US perceive a degree—however small —of political risk in placing their funds in the US (eg, the Soviets in the fifties and the oil exporting Arab countries in the seventies), eurobanks can attract deposits even if they pay a somewhat smaller rate of interest. The second explanation emphasises the supply side, viz. impact of regulation on banks’ cost of funds, Banks in the US are subject to reserve requitements as well as insurance premia for Federal Deposit Insurance. This would mean a higher cost of funds for a_given rate paid on deposits. Eurobanks are exempt from both these restrictions and can therefore afford to pay somewhat higher rates. ‘Thus suppose, both pay interest at 10% per annum, assume that reserve requirements in the US are 5% and deposit insurance costs 0.1% per annum. Then the effective cost of funds for the US bank would be (10 + 0.1)/(1 - 0.05) = 10.63% while for the eurobank it is 10%"”. The US bank can pay interst only at the rate of 9.4% to achieve a cost of funds equal to 10%. Exhibit 1.7 shows that the eurodollar rates are generally somewhat higher than their domestic counterparts. ‘There may also be a third factor at work though its influence is likely to be small. Depositors outside the US may prefer off-shore banks on account of the convenience of time zone and. greater familiarity with banking practices. Exhibit 1.7 US Dollar 3-Month Domestic and Offshore Interest Rates (%) oP cD TIBOR 2007 APR 5.20 531 5.35 2007 MAY 519 5.31 5.35 2007 JUN 23 5.33 5.36 2007 JUL 522 5.92 5.14 2007 AUG 525 5.49 468 2007 SEP 492 5.48 309 2007 OCT 463 5.08 536 2007 NOV 442 497 535 2007 DEC. 423 5.02 567 2008 JAN 325 384 523 2008 FEB 272 3.08 487 2008 MAR 235 279 3.01 2008 APR. 1.99 2.05 268 2008 MAY 2.00 2.68 278 ‘Source: Federal Reserve Board ¥ This is not strictly true. Even though curobanks are not subject to legal reserve requirements, they will nevertheless keep some reserves for prudential reason.Global Financial Environment v7 The cost-of-funds arguments would also imply that eurobanks would charge slightly lower rates on loans than their domestic counterparts since their cost of fund is somewhat lower. In practice, neither argument—risk premium or cost of funds—by itself is adequate to explain the interest differentials at all times. Both have to be invoked depending upon specific market conditions. From time to time, for balance of payments reasons or to prevent speculation against their currency, national authorities may impose temporary controls on cross-border funds flows. This results in divided capital markets as arbitrage transactions are not permitted, Under these circumstances the close linkage between domestic and off-shore rates is snapped. The most dramatic instance of such segmented credit markets is what happened to the Euro-French Franc market in the early 1980s. Then, to prevent speculation against the French franc the authorities had imposed various controls on resident and non-resident borrowers and investors and banks. This led to the Euro-French franc deposit rates being much higher than corresponding, domestic deposit rates. For a brief history of this episode see Giddy (1994). Next, let us examine the linkages between the interest rates for different currencies in the euromarket. As seen in Exhibit 1.4, at any point in time, LIBORs for different currencies differ substantially. Consider a borrower who wished to borrow funds in the euromarket for six months. Why would such a borrower take a loan in pound sterling paying 5.84% and not in Japanese yen paying 0.98%? Obviously this must have something to do with the expected behaviour of exchange rates. For concreteness, assume that the depositor’s functional currency is Indian rupees. After taking a loan in a foreign currency he converts it into rupees and uses the funds for whatever purpose. To repay the loan with interest he will need the foreign currency six months later. To eliminate the uncertainty about the rate at which he will be able to buy the currency at that time, he enters into a contract with his bank in which the bank agrees to sell him the foreign currency at a rate specified now. This is the forward exchange rate. in choosing between a pound sterling and a Yen loan, the depositor would compare the end-of-period rupee cash outflows from both for a given rupee inflow today. This comparison involves two factors, viz. the interest rates to be paid and the forward exchange rate at which the currency of Joan can be bought against rupees when the loan has to be repaid. Suppose on March 20 2008 the following rates were available: Pound sterling 6-month LIBOR: 5.80% pa. Japanese yen é-month LIBOR: 0.95% pa. Spot Exchange Rate Rupees vs. Pound: Rs 88.00 per pound 6-month forward exchange rate Rupees vs. Pound: 89.35, Spot Exchange Rate Rupees vs.Yer: 0.4600 é-month forward exchange Rupees vs. Yen: 0.4940 Suppose the funds requirement is Rs 500 million. (@) A loan in pounds would require a principal amount of (500,000,000/88) or 5,681,818.18 pounds. The repayment obligation six months later would be 5,681,818.18[1+ (0.058 /2)] = 5,846,590.91 pounds To buy this at the forward rate of Rs 89.35 per pound would require an outlay of: Rs (5,846,590.91 x 89.35) = Rs 522,392,897.70 or about Rs 522.4 million six months later. a Phere18 International Finance (b) The principal amount of the yen loan would be (500,000,000/0.4600) or 1,086,956,522 yen. The repayment would be 1,086,956,522 [1 + (0.0095/2)] = 1,092,119,565 yen To buy this forward would require an outlay of Rs (1,092,119,565 x 0.4940) = Rs 539,507,065.10 or almost Rs 540 million six months later. This is about Rs 18 million more than the outlay required with a pound loan. Thus even with an apparently much more attractive interest rate, the yen loan turns out to be a more expensive proposition than the pound sterling loan The key lies in the fact that the effective cost of the loan consists of two components, viz. the interest rate and the loss or gain on currency conversion. The latter in turn depends upon the exchange rate at the start and the rate at which conversion is done at the time of loan repayment. Inthe example, at loan maturity the borrower had to buy the foreign currencies at a rate higher than the rate at the start—both yen and pound were ata “forward premium”. The difference in the spot rate and the forward rate more than wiped out the benefit of lower interest rate for the yen loan. Of course, the borrower need not have entered into a forward contract; he could have bought the necessary foreign exchange in the spot market at the time of loan repayment. It is then possible that the yen loan might have tured out to be cheaper but it could go the other ‘way too. The borrower would have been exposed to currency risk. What does this imply for the market rates? Obviously ali borrowers from India choosing, between pound and yen loan and not wishing to take exchange rate risk, would opt for pound Joan, Here note that the exchange rates of yen and pound against the rupee given above imply the following rates between yen and pound: Yen per pound spot: (88.00/0.4600) = 191.30 ‘Yen per pound 6-months forward: (89.35/0.4940) = 180.87. Asan exercise work out the following: A British company needsa 6-month 5 million sterling oan and does not wish to take on currency risk. Should it take a sterling loan or a yen loan? A Japanese firm needs a 6-month 500 million yen loan without currency exposure. In which currency should it borrow? You will find that in both the cases the answer is they should go in for a pound loan. How would the spot and forward exchange rates and interest rates be affected by the market forces of supply and demand, as a result of these choices? As we will see in Chapters 2 and 3, they would move in such a way that interest rate differential between two currencies would equal the percentage spot-forward exchange rate margin. Because of this, a borrower who does not wish to incur currency risk would be indifferent to the currency of loan. For him the effective cost of funds would be same in all currencies. Now consider a similar situation from another angle. This time an investor in Singapore is examining bank deposits in various currencies as a short-term investment. He observes the following rates: Spot Exchange Rate Singapore dollar (SGD) per Swiss franc (CHF); 1.1000 Europound 6-month LIBOR: 6.64% p.a. EuroCHF 6-month LIBOR: 2.06% pa. 6-month forward exchange rate SGD vs. CHF: 1.1107 3Global Financial Environment 19 Spot Exchange Rate SGD vs. Pound: 2.8000 6-month forward exchange rate SGD vs. Pound: 2.7475 (a) 100 SGD put in a CHE deposit for six months, maturity value of deposit sold forward. ‘On exchanging 100 SGD at the spot rate of 1.1, he would get CHF (100/11), which after a six month deposit would mature to CHF {(100/1.1)(1+0.0206/2)}. On converting this maturity value back to SGD, at the forward exchange rate of 1.1107, he would get SGD {(100/1.1)(1.0.0103)|(1.1107) = SGD (102.0128) (b) 100 SGD put in a pound sterling deposit for sit: months, maturity value of deposit sold forward. By converting 100 SGD to GBP at the spot rate and placing the GBP in a six month deposit and reconverting the maturity value of the GBP deposit back to SGD at the forward rate, at the end of six months the depositor would have: ‘SGD [(100/2.80)(1.0332)(2.7475)] = SGD (101.3827) ‘Thus despite the higher interest rate on sterling deposits, the depositor would have been better off putting money in a Swiss franc deposit. Why was this so? The key again lies in the Joss or gain made when converting the deposit proceeds back into the depositor’s home currency with a forward foreign exchange deal. With a Swiss franc deposit the depositor gains. The percentage gain is: [(2.1107 - 1.1000)/1.1000] x 100 = 0.9727 for six months. (On annualized basis, this gain is 1.945%. Adding to this the annual interest of 2.06% p.a. earned on the SGD deposit, the effective return is 4.005% per annum or 2.0028% for six months. With a sterling deposit, the depositor loses; the percentage loss is: (2.7475 — 2.8000)/2.8000] x 100 = -1.875% for six months or -3.75% per annum. With annual interest at 6.64%, the effective return is 2.89% per annum. Note also that this return is less than the return offered by SGD deposits. Obviously, if all depositors—including those in UK—are free to place their funds in any currency, such a situation cannot last. In the present case, depositors who hold sterling deposits would liquidate them, buy SGD or CHF in the spot market, put these on deposit and simultaneously enter into forward contracts to convert the deposit proceeds back into sterling This activity is known as Covered Interest Arbitrage. We will examine it in much greater depth in Chapters 2 and 3. When all or even a large number of investors attempt to put through such transactions, the market rates would change. For instance, deposit rates on sterling would tise, those on SGD and CHF would fall, spot price of sterling would fall and the forward price would rise, In equilibrium, the effective returns on all currencies—ie interest plus any exchange gain or loss—would be equalised. You can convince yourself that the fact that we have assumed the functional currency of the depositor to be SGD is of no consequence. Thus the differences in interest rates between different currencies in the euromarket reflect the market's expectations regarding exchange rate movements as captured in the spot rate-forward rate differentials. On a covered basis—ic. protected against currency risk—all currencies should yield equal returns or equal funding costs. As we will see in Chapter 3, empirically this proposition is found to be valid to a close degree of approximation for currencies which are fully convertible. In reality, transaction costs, taxes and differences across markets in regulatory practices such as reserve requirements will create divergences between effective yields on different currencies which cannot be arbitraged away. ° ur20 International Finance To summarise, the relationship between the domestic and offshore market interest rates for a currency is governed by risk premia, reserve requirements and other regulations that apply todomesticdeposits and the presence of capital controls. The differences in interest rates between currencies in the global money market are also related to the spot-forward margins in the foreign exchange market via the covered interest parity mechanism. In equilibrium, covered —i.e,, hedged for exchange risk—returns on all currencies would be equal. 1.5 = THE INTERNATIONAL MONETARY SYSTEM. ‘The purpose of this section isto provide a succinct overview of the organisation and functioning of the international monetary system. The discussion will be structured around the following aspects of the system which we consider to be the key areas a finance manager must be acquainted with: 1. Exchange rate regimes, current and past. 2. International liquidity, ie. the volume and composition of reserves, adequacy of reserves, ete. The International Monetary Fund, its evolution, role and functioning. ‘The adjustment process, ie. how does the system facilitate the process of coping with payments imbalances between trading nations? 5. Currency blocks such as the Economic and Monetary Union (EMU) in Europe. We will discuss only the bare essentials of these topics. Details can be found in some of the specialised works on international monetary economics cited in the bibliography. ee + Exchange Rate Regimes Anexchange rate is just the value of one currency in terms of another. The term exchange rate regime refers to the mechanism, procedures and institutional framework for determining, exchange rates ata point in time and changes in them aver time, including factors which induce the changes. At one end of the spectrum we have rigid or fixed exchange rates and at the other end, perfectly flexible or floating exchange rates. Spanning, them are hybrids with varying degrees of limited flexibility. We will discuss the main prototypes that have characterised the international monetary system in this century and a few which have been proposed as.a part of the reform of the system. Fixed and Quasi-Fixed Systems (a) The Gold Standard. This is the oldest system which was in operation till the beginning of the First World War and fora few years after that. It comes in three different versions'*. 2 Tn the Gold Specie Standard the actual currency in circulation consists of gold coins with a fixed gold content, Jn the Gold Bullion Standard here the basis of the currency in circulation consists of paper notes which are convertible into gold at a fixed rate. In the Gold Exchange Standard, the authorities stand ready to convert, at fied rate the paper currency issued by them into the paper currency of another country which is operating a gold-specie or gold-bullion standard. Thus if rupees are freely convertible into dollars and dollars in tum. into gold, rupee can be said to be on a gold-exchange standard. eweGlobal Financial Environment n ‘The essence of all the three versions is that the currency in circulation is convertible into gold ata fixed rate. Thus the exchange rate between any two currencies is determined by their respective values in terms of gold. Thus if a given quantity of gold is convertible into two dollars or one pound the mint parity exchange rate between dollars and pounds should be 2.00 dollars per pound”. ‘The gold standard regime imposes very rigid discipline on the policy makers, Often, domestic considerations such as full employment have to be sacrificed in order to continue operating the standard and the political cost of doing so can be quite high. For this reason, the system ‘was rarely allowed to work in its pristine version, (b) The Bretton Woods System ‘A series of events” during the late 1920s and 1930s, including the breakdown of the gold standard, plunged the world monetary system ina state of chaosand the volume of international trade fell substantially. The exchange rate regime that was put in place after the second World War by the victorious allies can be characterised as the Gold Exchange Standard. It had the following features: 1 The US government undertook to convert the US dollar freely into gold at a fixed parity of $35 per ounce. International Monetary Fund was created to act as a sort of central bank to member countries’ central banks. 3 Other member countries of the IMF agreed to fix the parities oftheir currencies vis-a-vis thedollar with variation within 1% on either side of the central parity being permissible. If the exchange rate hit either of the limits, the monetary authorities of the country were obliged to “defend” it by standing ready to buy or sell dollars against their domestic currency to any extent required to keep the exchange rate within the limits. This is called. “intervention”. In return for undertaking this obligation, the member countries were entitled to borrow from the IMF to carry out their intervention in the currency markets. Thus they could borrow currencies of other member countries subject to certain limitations and conditions. The novel feature of the regime which makes it an adjustable peg system rather than a fixed rate system like the gold standard was that the parity of a currency against the dollar could be changed in the face of a fundamental disequilibrium’. Changes of up to 10% in either direction could be ™ At any other exchange rate there would be incentive to buy gold in one country and sell it in the other to realise arbitrage profit. Of course, since storage and transport of gold is not costless, the exchange rate can depart somewhat in either direction from the mint parity rate. For a brief account of some of these see Yeager (1976), As we will see below this characterisation was valid till 1968 when it became a limping gold exchange standard. some countries, eg. India, chose to tie their currencies not directly to the dollar but to another currency like the pound sterling which in tum was tied to the dollar. 2 A fundamental disequilibrium is said to exist when at the given exchange rate the country repeatedly faces balance of payments disequilibria and has to constantly intervene and sell foreign exchange (persistent deficits) or buy foreign exchange (persistent surpluses) against its own currency. AS we will see below, the situation of persistent deficits is much more difficult to deal with and calls for a devaluation of the home currency. aes2 International Finance _ made without the consent of the Fund while larger changes could be effected after consulting the Fund and obtaining their approval. Let us see how the Breiton Woods system worked. In Exhibit 1.8 we have drawn a supply curve S-S and a demand curve D,-D, for dollars*. On the vertical axis we have plotted the price of dollars in terms of rupees, ie. the exchange rate between rupees and dollars. On the horizontal axis we have shown the quantity of dollars demanded and supplied. For the present you can imagine that the demand for dollars arises from Indian residents wanting to import American goods and services while the supply of dollars arises from Americans wishing to import goods and services from India (and therefore wishing to exchange their dollars for rupees). Suppose the parity exchange rate is Rs 12.00 per dollar. The 1% limits are therefore Rs 12.12 and Rs 11.88. These limits are called support points for reasons that will become clear shortly. Aslong as the demand and supply curves intersect within the permissible band, the Indian authorities need do nothing; the exchange rate resulting from autonomous demand and supply factors falls within the permissible band. However, suppose the demand curve shifts upward to the right due to a change in preferences of Indians in favour of American goods. This is shown by the curve Dj-D;. Now the “market determined” exchange rate would fall outside the band. The Indian authorities are obliged to prevent this by supplying dollars from. their reserves and buying rupees so that the exchange rate does not rise above the upper support point of Rs 12.12 per dollar. The authorities are supporting the value of the rupee by interoening in the market for foreign exchange. Exhibit 1.8 RslS | be s | o a1 Upper Suppo 00] Party 1128 | Lover Suppo is Dp | 2 | Dollars sold | |}. oeeet ‘ant of Dota In the reverse case, if the supply curve of dollars shifts downward to the right so that the exchange rate would tend to cross the lower support point of Rs 11.88 (US residents develop a strong liking for things Indian), the Indian authorities must stand ready to buy dollars and supply rupees to prevent it. At this point two questions arise. First, in supporting the value of = We have drawn the supply curve upward sloping and the demand curve downward sloping. What ensures that they will indeed have these conventional shapes? Is it possible that either or both of them will exhibit “perverse” behaviour in certain ranges of values ofthe exchange rate? The answer in the case ofthe supply ‘curve is “yes”. It depends upon the price elasticity of foreigners’ demand for our exports. FI20Global Financial Environment 2B the rupee, how can the Indian authorities supply dollars beyond a limit? After exhausting their own reserves, they can borrow dollars from the IMF or pethaps the US government. If the pressure on the rupee is temporary, this would permit them to ride out the period of rupee ‘weakness. What if the rupee comes under pressure repeatedly? Then they must devalue the rupee as happened for instance in 1966. Second, what is the impact of these interventions on the domestic money supply, interest rates, etc.? This will be clarified below. The Bretton Woods system lasted from 1944 to 1971. Problems began to emerge during the sixties as US BOP deficits started mounting. A series of events finally led to the US abdicating its role as the anchor of the world monetary system. The dollar-gold link was abandoned in August 1971 After an abortive attempt to salvage the system by means of a series of parity realignments, dollar devaluations (in terms of gold) and widening the bands of permissible variation around the central parities the system was finally laid to rest, unofficially, in 1973 and officially in 1978. The ea of floating exchange rates had begun. Floating Exchange Rate System and Its Variants Ina pure float, the exchange rate is determined purely by forces of demand and supply. Authorities have no exchange rate target and do not intervene to influence the exchange rate in any way. Demand for a currency arises from (a) traders wishing to import goods and services from the country of that currency, (b) from investors wishing to acquire assets denominated in that currency, and (c) from borrowers who have borrowed in that currency and wish to liquidate the liabilities or pay interest on the borrowings. Supply of the currency arises from similar transactions undertaken by residents of the country—(a) import of goods and services from the rest of the world, (b) acquiring foreign assets, (c) liquidating their foreign currency liabilities or paying interest on the foreign loans. The spot exchange rate would be determined by the relative strengths of demand and supply forces and change continually in response to changes in them®. The essential point is that no effort is made by the authorities to influence the current value and future evolution of the exchange rate, Truly free-floating rates have been a theoretical ideal. In practice, authorities have intervened more or less intensely in the foreign exchange markets. The resulting, “system” in which there are 1no officially declared parities but there is official intervention has come to be known as managed or dirty float. The degree and motives for intervention can range from ‘smoothing out short- term fluctuations” to “forcing the rate towards a particular target value’. In the former case, the system is close to a free float while in the latter case itis close to an adjustable peg. Between the two extremes of fixed and floating rates, a number of other alternatives have been suggested (and some have been tried) which try to combine the “good” features of both. The crawling peg system replaces the abrupt parity changes of the adjustable peg system with gradual modifications with permissible variations around the parity restricted toa narrow 25 Notice that in case the authorities have to support the value of the dolla tendency to fall in value below 11.88, the Indian authorities can supply rupees and buy dollars theoretically without limit; they can indefinitely postpone revaluation of the rupee. 26 It is simplistic to assume that the current exchange rate is determined solely by the current flow demand and flow supply of the currency. Expectations regarding,future movements in exchange rate will certainly influence the current exchange rate. The difficult topic of exchange rate deterrnination will be taken up later in this book. a4 Intemational Finance band (usually +1%). The change in parity per unit period (say a year) is subject to a ceiling with an additional short-term constraint, e.g. parity change in a month cannot be more than 1/12" of the yearly ceiling, In the system of Wider Bands the idea is to introduce more flexibility by permitting wider bands of variation around the central parity. The parity itself may be gradually shifted as in the crawling peg (gliding bands) or there may be discrete jumps like in adjustable peg. In multiple exchange rate systems different exchange rates apply to different transactions. For instance in 1992 India had an “official” exchange rate applicable to certaih imports and a “market determined” exchange rate for other transactions. * Exchange Rate Regimes: The Current Scenario” ‘The IMF classifies member countries into eight categories according to the exchange rate regime they have adopted. 1. Exchange Arrangements with No Separate Legal Tender: This group includes countries which are members of a currency union and share a common currency like the fifteen members of the Economic and Monetary Union (EMU) who have adopted Euro as their common currency. There are some other monetary unions with common currencies in Africa, e.g, Central African Economic and Monetary Union which has Cameroon, Central African Republic, Chad, etc.,as members and Caribbean, e.g. Caribbean Common Market which has Grenada, Antigua, St. Kitts and Nevis as members. In addition, there de facto monetary unions, ie. countries which have adopted the currency of another country as their currency. For example, Australian dollar is used by Kiribati, Nauru and Tuvalu and Andorra, Kosovo and Montenegro use Euro as their legal tender though they are not members of European Union. 2. Currency Board Arrangement: A reginte under which there isa legislative commitment toexchange the domestic currency against a specified foreign currency ata fixed exchange rate coupled with restrictions on the monetary authority to ensure that this commitment will be honoured. This implies constraints on the ability of the monetary authority to manipulate domestic money supply. As of 1999, eight IMF members had adopted a currency board regime including Argentina and Hong Kong tying their currency to the US dollar. 3. Conventional Fixed Peg Arrangements: This is identical to the Bretton Woods system. 4. Pogged Exchange Rates within Horizontal Bands: Here there is a peg but variation is permitted within wider bands. Bight countries had such wider band regimes in 1999. 5. Crawling Peg: This is described above. The adjustments to the peg may be discretionary or according to pre-announced rules. Six countries were under such a regime in 1999. 6. Crawling Bands: The currency is maintained within certain margins around a central parity which “crawls” as in the crawling peg regime either in a pre-announced fashion or in response to certain indicators. Nine countries could be characterised as having such an arrangement in 1999. 2 This section is based on the information provided in International Financial Statistics Yearbook 1999, IMF. “Global Financial Environment 8 7. Managed Floating with no pre-announced path for the Exchange Rate: The central bank influences or attempts to influence the exchange rate by means of active intervention in the foreign exchange market—buying or selling foreign currency against the home currency—without any commitment to maintain the rate at any particular level or keep iton any pre-announced trajectory. Twenty five countries could be classified as belonging to this group. & Independently Floating: The exchange rate is market determined with cenéral bank intervening only to moderate the speed of change and to prevent excessive fluctuations but not attempting to maintain it at or drive it towards any particular level. In 1999, forty eight countries including India characterised themselves as independent floaters. + Is There an Optimal Exchange Rate Regime? ‘The world has experienced three different exchange rate regimes in this century in addition to some of their variants tried out by some countries. Starting from the gold standard regime of fixed rates, passing through the adjustable peg system after the Second World War it finally ended up with a system of managed floats after 1973. Since 1985, the pendulum has started swinging, though very slowly and erratically, in the direction of introducing some amount of fixity and rule based management of exchange rates. The fixed versus floating exchange rates controversy is at least four decades old. Even a brief review requires some understanding of open economy macroeconomics which is outside the scope of this book. Suffice it to say that after the actual experience of floating zates for nearly two decades, the sober realisation has come that the claims made in their favour during the fifties and sixties were rather exaggerated. The economic crises—in particular high inflation rates—which a number of developing countries in Latin America and elsewhere experienced during the late 1970s and 1980s led many economists to reconsider the merits of a floating exchange rate and monetary policy independence which it apparently bestows on a country. By tke end of 1980s many economists had started recommending a hard peg via a currency board-like arrangement. The fact that the Hong Kong economy emerged out of the East Asian crisis of 1997 relatively unscathed was attributed to its currency board arrangement with the US dollar. The success of the Argentinian economy in achieving stability and bringing inflation under control in the 1990s was also attributed to the hard peg of the peso to the US dollar. However by 2001, things were not looking so rosy for Argentina. Its external account was in deep crisis and the cost of borrowing at home and abroad had gone up steeply because of fears of default. Thus, currency boards bring troubles of their own as do other exchange rate arrangements. Systems with crawling pegs, crawling bands and other “mixed” varieties have not fared better either as shown by the experiences of Indonesia, Brazil and Turkey. It appears therefore that there is no such thing as “the ideal” exchange rate regime for all countries or even for a given country at al times. Despite these empirical facts, there sa school of thought within the profession which argues that in the years to come, there will be only two types of exchange rate regimes: truly fixed rate arrangements like currency unions or currency boards or truly market determined independently floating exchange rates. The “middle ground” —regimes such as adjustable pegs, crawling pegs, crawling bands and managed floating—will pass into history. Some anglysts6 International Finance even predict that three currency blocks—the US dollar block, the Euro block and the Yen block —will emerge with currency union within each and free floating between them. The argument for the impossibility of the middle ground refers to the “impossible trinity”, ie. it asserts that a country can achieve any two of three policy goals but not all three: (i) A stable exchange rate, (ii) A financial system integrated with the global financial system, ie. an open capital account, and_ (ii) Freedom to conduct an independent monetary policy. Of these, (i) and (ii) can be achieved with a currency union or board, (ii) and (ii) with an independently floating exchange rate, and (i) and (fii) with capital controls. Exhibit 19 provides a graphical representation of the impossible trinity argument. This assertion has been strongly contested by many economists. To get a flavour of the controversy the reader should consult the references cited at the end of this chapter. Exhibit 1,9 The Impossible Trinity FULL CAPITAL CONTROLS Monetary Exchange Rete Independece Stability Pure Float Union Integration with Global Financial System Asofnow, there is no consensus either among academic economists or among policy makers or among businessmen and bankers.as to the ideal exchange rate regime. The debate is extremely. complicated and made more so by the fact that itis very difficult if not impossible to sort out the effects of exchange rate fluctuations on the world economy from those of other shocks, real and monetary (oil price gyrations, sub-prime crisis in the US, Mid-East wars, political developments in East Europe, disagreements over trade liberalisation, developing country debt crisis, etc.) Macroeconomic policy making within an economy has become an extremely complex and demanding task. With open economies and integrated financial markets, a given monetary or fiscal policy action can have a variety of conflicting or complementary impacts on important policy targets like employment, inflation and external balance. Market overreaction and speculative asset price bubbles can do lasting damage as evidenced by the currency crises ‘which ravaged the East Asian economies in 1997. Under these conditions, policy combination of extensive capital controls and a pegged exchange rate—with of course an adjustable peg— is becoming attractive particularly for developing economies. Attempts have been made to devise exchange rate policy guidelines based on the concept of Equilibrium Real Effective Exchange Rate. This concept will be discussed at some length in Chapter 2, In simple terms, effective exchange rate is a kind of purchasing power weighted average of a currency’s exchange rates against a group of currencies. The idea isto set a target “Theme: Dynamics of Forex Market and Exchange Rate MechanismChapter 3 The Foreign Exchange Market OnjecrivEs ‘The purpose of this chapter is to examine the structure and functioning ofthe foreign exchange market, both global and Indian. The chapter will cover both the spot and forward markets in foreign exchange. In the appendix to the chapter we will briefly describe some institutional features of the Indian forex market. At the end of the chapter you will have learnt: ‘The global forex market—size, structure and participants. Market makers and price takers ‘The spot market~two way prices, different types of rate quotations, arbitrage between banks and across markets, direct versus brokers’ markets. Forward market—Outright and swap quotations, option forwards, covered interest arbitrage and one-way arbitrage, swaps and their uses, The Indian forex market—Participants, rate quotes and arithmetic, general regulatory framework, ‘mechanics of cancellation, extension and early delivery with forward contracts. Carrer SuMMARY AND LE 3.1 § INTRODUCTION the foreign exchange market is the market in which currencies are bought and sold against each other. tis the largest market in the world, The average daily turnover in April 2007 in the traditional foreign exchange markets is estimated to be 3200 billion US dollars as per the survey conducted the Bank for International Settlements (BIS). Bulk of this is accounted for by small number of currencies the US dollar, Euro, Yen, Pound Sterling, Swiss franc, Canadian dollar, and Australian dollar. This survey reported the following currency pair-wise break-up of all foreign exchange transactions around the world excluding inter-dealer trades: USD/EURO: 27% — USD/YEN:13% — USD/POUND: 12% USD/SFR:5% —USD/CANADIAN DOLLAR: 4% USD/ AUSTRALIAN DOLLAR: 6% USD/SWEDISH KRONA: 2% USD/ALL OTHERS: 19% “The Foreign Exchange Market a The foreign exchange market is an over-the-counter market. This means that there is no single physical or electronic marketplace or an organised exchange (like a stock exchange) with a central trade clearing mechanism where traders meet and exchange currencies. The market itself is actually a worldwide network of inter-bank traders, consisting primarily of banks, connected by telephone lines and computers. While a large part of inter-bank trading takes place with electronic trading systems such as Reuters Dealing 2000 and Electronic Broking Systems, banks and large commercial, i. corporate customersstill use the telephone to negotiate prices and consummate the deal, After the transaction, the resulting market bid/ask price is then fed into computer terminals provided by official market reporting service companies (networks such as Reuters®, Bridge Information Systems®, Telerate®). The prices displayed on official quote screens reflect one of maybe dozens of simultaneous ‘deals’ that took place at any given moment, New technologies such as the Interpreter 6000 Voice Recognition System— ‘VRS— which allows forex traders to enter orders using spoken commands, are presently being tested and may be widely adopted by the inter-bank community in the years to come. On-line trading systems have also been devised and may become the norm in the near future. However, for corporate customers of banks, dealing on the telephone will continue to be an important channel. ‘The markets span all the time zones of the world and functions virtually round the clock enabling a trader to offset a position created in one market using another market. Of course, of the dozen or so market centres the really major ones are London, New York and Tokyo. Other important centres are Zurich, Frankfurt, Hong Kong and Singapore. 3.2 2 STRUCTURE OF THE FOREIGN EXCHANGE MARKET Some of us are familiar with the retail market in foreign exchange. This is the market in which travellers and tourists exchange one currency for another in the form of currency notes or travellers’ cheques. The total turnover and average transaction size are very small. The spread between buying and selling prices (see below) is large. ‘The market we will be discussing in this chapter is the wholesale market, often called the interbank market. The participants in this market are commercial banks, investment banks, corporations and central banks. The average transaction size is very large (many deals may be for several millions of US dollars or equivalent in other currencies). Among these participants, primary price makers or professional dealers make a two-way market to each other and to their clients, ie. on request they will quote a two-way price and be prepared to take either the buy or the sell side, This group includes mainly commercial banks but some large investment dealers and a few large corporations have also assumed the role of primary dealers. Primary price makers perform an important role in taking positions off the hands of another dealer or corporate customer and then offsetting these by doing an opposite deal with another entity which has a matching requirement. Thus a primary dealer will sell USD against EURO to one corporate customer, carry the position for a while and offset it by buying USD against EURO from another customer or professional dealer. ‘Among the primary price makers there isa kind of tiering. A few giant multinational banks deal in a large number of currencies, in large amounts and often deal directly with each other without using brokers. Their transactions can have significant influence on the market. In the «08 International Finance second tier are large banks who deal in a smaller number of currencies and use the services of brokers more often. Lastly there are small local institutions which make market in a very small number of major currencies against their home currency. In the retail market there are entities which make foreign exchange prices but do not make a two-way market. They are secondary price makers, Restaurants, hotels, shops catering to tourists buy foreign currency in payment of bills; some entities specialise in retail business for travellers and buy and sell foreign currencies and travellers’ cheques. Typically their bid-ask spreads are much wider than those of primary price makers Foreign currency brokers act as middlemen between two market makers. Their main function is to provide information to market-making banks about prices at which there are firm buyers and sellers in a pair of currencies. A bank may instruct a broker to buy or sell a specific amount of currency X against currency Y at a specific price or give a price limit. The broker hunts around for an appropriate counterparty —another bank—and collects a commission on conclusion of the deal. Banks may also use brokers to acquire information about the general state of the market even when they do not have a specific deal in mind, Primary price makers may use brokers to “show” their prices to the market anonymously. By specialising in certain pairs of currencies and maintaining constant contact with market makers brokers tend to possess much more information than the dealers themselves. The important thing is brokers do not buy or sell on their own account. Finally, there are price takers who take the prices quoted by primary price makers and buy cr sell currencies for their own purposes but do not make a market themselves. Corporations use the foreign exchange market for a variety of purposes related to their operations. Among these are payments for imports, conversion of export receipts, hedging of receivables and payables, payment of interest on foreign currency loans, placement of surplus funds and so forth. Many non-financial companies, as a matter of policy, restrict their participation in the market to transactions arising out of their business of producing and selling goods and services. They donot take active positions in the market to profit ftom exchange rate fluctuations, Others, mainly giant multinationals, utilise their considerable financial expertise to take positions purely with the intention of generating financial profits from exchange rate movements, Central banks intervene in the market from time to time to attempt to move exchange rates in a particular direction. Inthe case of limited flexibility systems like the EMS, these interventions are obligatory and, when intervention limits are reached, potentially unlimited. In other cases, though there is nocommitment to defend any particular tate, a central bank may still intervene to influence market sentiment, reduce short-term volatility or create “orderly conditions” in the foreign exchange market. Of the total volume of transactions, 85-90% is accounted for by interbank transactions and the rest by transactions between banks and their non-bank customers, This is implicit in the total turnover figure mentioned earlier which is nearly ten times the value of world trade in goods and services, Thus foreign exchange flows arising out of cross-border exchanges of goods and services account for a very small proportion of the turnover in the foreign exchange market the rest being on account of capital account transactions. Also, since banks usually aim to maintain square or near-square positions, a lot of the turnover is simply attributable to banks offsetting their positions. Thus bank A may buy US dollars against euros from company X; bank B buys euros against dollars from company Y. The banks may then offset their positions with bank A selling dollars to and buying euros from bank B.The Foreign Exchange Market 79 There is no distinct class of “speculators” in the foreign exchange market, Price making banks often carry uncovered positions to profit from exchange rate movements; so do corporations who have extensive foreign currency dealings arising out of their operations. Individuals, hedge fund managers and even governments through their central banks often seek to derive gains out of exchange rate movements by investing in assets denominated in currencies which they think are going to appreciate. Itis very difficult to demarcate speculation from prudent business decisions. A non-financial corporation which does not hedge its foreign currency export receivable or import payable is as much a speculator as a fund manager who moves funds out of one currency into another to profit from appreciation of the latter currency. ‘A.variety of trading platforms are used by dealers in the Emerging Market Economies (EMEs) for communicating and trading with one another on a bilateral basis. They conduct bilateral trades through telephones that are later confirmed by fax or telex. Some dealers also trade on electronic trading platforms that allow for bilateral conversations and dealing such as the Reuters Dealing 2000-1 and Dealing 3000 Spot. systems. Bilateral conversations may also take place over networks provided by central banks and over private sector networks (Brazil, Chile, Colombia, Korea and the Philippines). Reuters’ Dealing System has been the most popular trading platform in EMEs. 3.3 E THE MECHANICS OF CURRENCY TRADING As discussed above, the main actors in the forex markets are the primary market makers who trade on their own account and make a two-way bid-offer market. They deal actively and continuously with each other and with their clients, central banks and sometimes with currency brokers. In the process of dealing, they shift around their quotes, actively take positions, offset positions taken earlier or roll them forward. Their performance is evaluated on the basis of the amount of profit their activities yield and whether they are operating within the risk parameters established by the management. It is a high tension business which requires an alert mind, quick reflexes and the ability to keep one's cool under pressure. ‘The purpose of this section is to briefly outline the mechanics of actual currency trading as practised by the primary market makers. We wish to give the reader a flavour of the various dimensions involved in operating in this huge, fast changing global market, For more details the reader can consult specialist texis such as Bishop and Dixon (1992), or Taylor (1997). Even then, keep in mind that the only way to leam all the intricacies of forex dealing is to actually do it. Before proceeding let us clarify the way we will designate the various currencies in this book. ‘The International Standards Organization has developed three-letter codes for all the currencies which abbreviate the name of the country as well as the currency. Depending upon the context we will either use the full name of a currency such as Pound sterling, Swiss franc, US dollar, etc. or the ISO code. A complete list of ISO codes is given at the end of this book. Here we will give the codes for selected currencies which will be frequently used in the various examples. USD: US Dollar EUR: Euro GBP: British Pound CHE: Swiss Frane JPY: Japanese Yen AUD: Australian Dollar CAD: Canadian Dollar SEK: Swedish Kroner INR: Indian Rupee80 International Finance. Some of the major European currencies which have become legacy currencies after June 2002: NLG: Dutch Guilder BEF: Belgian Franc FRF: French Franc ‘DEM; Deutsche Mark ESP: Spanish Peseta TTL: Italian Lira Further, unless otherwise stated, “dollar” will always mean the US dollar, “pound” or “sterling” will always denote the British pound sterling and “rupee” will invariably mean the Indian rupee. We will frequently use just the symbols “$", “£” and “¥” to designate the USD, the British pound and the Japanese yen respectively. Interbank Dealing We have said that primary dealers quote two-way prices and are willing to deal on either side, ie. buy or sell the base currency up to conventional amounts at those prices. However, in interbank markets, this is a matter of mutual accommodation. A dealer will be shown a two-way quote only if he or she extends that privilege to fellow dealers when they call for a quote. ‘Communications between dealers tend to be very terse. / typical spot transaction would be dealt as follows: Monday September 21.10.45 am BANK A: “Bank A calling. EUR-DLR 35 please. (Bank A dealer is asking for a Euro versus US dollar quote. She specifies the size of the deal, viz. 35 million euros since this is more than the “market lot” which may be around 15 million euros.) BANK B: “Forty-Fortyfive” (Bank B is specifying a two-way price—the price at which it will buy a euro against US dollar and the price at which it is willing to sell a euro. Knowing that the caller is also a forex dealer, the dealer in Bank B quotes only the last two decimals of the full quotation. For instance the full quotation might be 1.3740/13745. Bank B will pay USD 1.3749, its “bid rate”, when it buys a euro and will want to be paid USD 1.3745, its “ask rate” when it sells a euro, The last two decimals amount to hundredths of a hundredth and are called “points” or “pips” in the forex jargon. The difference between the selling and buying price 0.0005 or 5 “pips” is the bid- ask spread. Ifthe caller had been a corporate customer, the dealer would have given the full quote.) BANK A: “Mine” (Bank A dealer finds bank B's price acceptable and wishes to buy EUR35 million, She conveys this by saying “mine”, ie. !buy the specified quantity at your specified price. If she wished to sell, she might have said “Yours” ) BANK B: OK. I sell you EUR 35 million against USD at 1.3745 value 23 September. CITY NY for my USD. (Bank B confirms the quantity, price and settlement date. It also specifies where it would like its USD to be transferred.) 82 patsThe Foreign Exchange Market at BANK A: COMMERZBANK F Furt for my EUR. Thanks & Bye. When a dealer A calls another dealer B and asks for a quote between a pair of currencies, dealer B may or may not wish to take on the resulting position on his own books. Ifhe does, he will quote a price based on his information about the current market and the anticipated trends and take the deal on his own books. This is known as “warehousing the deal”. If he does not wish to warehouse the deal, he will immediately call a dealer C, get his quote and show that quote to A. If A does a deal, B will immediately offset it with C. This is known as “back-to- back” dealing. Normally, back-to-back deals are done when the client asks for a quote on a currency which the dealer does not actively trade. In the inter-bank markets bulk of the dealing nowadays is done with computerised dealing systems such as Reuters 2000. These systems permit a dealer to carry on multiple conversations simultaneously and provide a visual record of what is being conveyed by voice. Once the deal is finalised all the relevant information —identity of the counterparty, the currency pair, amounts, agreed upon exchange rate, details of bank accounts to which funds are to be transferred etc. — are automatically entered into a computer to be processed later by the “backroom” staff. Real- time information on exchange rates is provided by a number of information services including Reuters, Bridge, and Bloomberg Computerised dealing systems allow a dealer to carry on multiple conversations simultaneously and provide a visual reproduction of the audio exchange between the dealers. This minimises the likelihood of mistakes and discrepancies. Ina normal two-way market, a trader expects “to be hit” on both sides of his quote in roughly equal amounts. That is, in the dollar-euro case above, on a normal business day the trader expects to buy and sell roughly equal amount of dollars (and of course euros). The bank's margin would then be the bid-ask spread. But suppose during the course of trading a trader finds that he is “being hit” on one side of his quote much more often than the other side. In our example this means that he is either buying many more dollars than he is selling or vice versa. This leads to the trader building up “a position’. Ifhe has sold (bought) more dollars than he has bought (sold) he is said to havea net short position (long position) in dollars. Given the volatility of exchange rates, maintaining a large net short or long position for too long can bea risky proposition. For instance, suppose that a trader has built up a net short position in dollars of $5,000,000. The dollar suddenly appreciates from say USD 1.3745 per EUR to USD 1.3550. This implies that the bank's liability increases by: EUR [(Sm/13550) ~ (5m/1.3745)] = EUR 5235047 Of course, dollar depreciation would have resulted in a gain. Similarly, a net long position leads to a loss if ithas to be covered at a lower price and a gain f ata higher price. (By “covering a position” we mean undertaking transactions that will reduce the net position to zero. A trader net long in dollars must sell dollars to cover; a net short must buy dollars)! * Positions can be covered by borrowing or lending in the interbank deposit market. For instance, abank may sell more dollars than it buys and borrow dollars. It will do this iit expects to buy dollars later at a price sufficiently low to compensate for the interest cost on borrowing, Ey82 International Finance The potential gain or loss from a position depends upon the size of the position and the variability of exchange rates. Building and carrying such net positions for long durations would be equivalent to speculation and banks exercise tight control over their traders to prevent such . This is done by prescribing the maximum size of net positions a trader can build up during a trading day and how much can be carried overnight”. When a trader realises that he is building up an undesirable net position he will adjust his bid-ask quotes in a manner designed to discourage one type of deal and encourage the opposite deal, For instance a trader who has overbought say Swiss francs against the US dollar, will want to discourage further sellers of francs and encourage buyers. If his initial quote was say 1,3500-1.3510 francs per dollar, he might move it to 1.3508-1.3518, ie. offer more francs per dollar sold to the bank and charge more francs per dollar bought from the bank. Since most of the trading takes place between market-making banks, itis a zero-sum game, i. gains made by one trader are reflected in losses made by another. However, when central banks intervene, itis possible for banks as a group to gain or lose at the expense of the central bank. Bulk of the trading of convertible currencies takes place against the US dollar. Thus quotations for, Swiss francs, Japanese yen, British pound sterling, etc. will be commonly given against the US dollar. Ifa corporate customer wants to buy or sell yen against say Swiss franc, a cross-rate will be worked out from the USD/CHF and USD/PY quotation as explained in later section, One reason for using a common currency (called the “vehicle currency”) for all quotations is to economise on the number of quotations. However, some banks specialise in giving these so- called cross-rates. As we will see below, they can operate witha smaller bid-ask spread provided there is sufficient turnover of business in the currency pair concerned. Inan ordinary foreign exchange transaction, no fees are charged. The bid-ask spread itselfis, the transaction cost. Also, unlike the money or capital markets, where different rates of interest are charged to different borrowers depending on their creditworthiness, in the wholesale foreign exchange market no such distinction is made, Default risk— the possibility that the counterparty ina transaction may not deliver on its side of the deal—is handled by prescribing limits on the size of positions a trader can take with different corporate customers. ‘Communications pertaining to international financial transactions are handled mainly by a large network called Society for Worldwide Interbank Financial Telecommunication (SWIFT). This is a non-profit Belgian co-operative with main and regional centres around the world connected by data transmission lines. Depending on the location, a bank can access a regional processor or a main centre which then transmits the information to the appropriate location. When banks deal through brokers they transmit their buy and sell orders to a broker who “shows” them to the market without revealing the identities of the parties. Ifa particular bid or offer is accepted the broker brings together the two parties and consummates the deal collecting a commission from both. 2 This is where the importance of having a nearly 24-hour globally interconnected market comes in. Imagine atrader in New York who enters intoa large deal to sell Japanese Yen toa corporate customer against dollar in the late afternoon when the activity in the New York market has already slowed down, He may find it ‘very difficult to locate a counterparty to do the offsetting deal ~sell him yen against dollar—in the New York market at that hour. He can wait for a couple of hours till the Tokyo market opens and square his position rather than carry an overnight short position in yen, stThe Foreign Exchange Market 83 3.4 2 TYPES OF TRANSACTIONS AND SETTLEMENT DATES. As we said above, settlement of a transaction takes place by transfers of deposits between the twvo parties. The day on which these transfers are effected is called the settlement date or the value date. Obviously, to effect the transfers, banks in the countries of the two currencies involved must be open for business. The relevant countries are called settlement locations. The locatioas of the two banks involved in the trade are dealing locations which need not be the same as settlement locations, Thus a London bank can sell Japanese yen against US dollar to a Paris bank. Settlement locations may be New York and Tokyo, while dealing locations are London and Paris, The transaction can be settled only on a day on which both US and Japanese banks are open. Depending upon the time elapsed between the transaction date and the settlement date, foreign exchange transactions can be categorised into spot and forward transactions. A third category called swaps are combination of a spot and a forward transactions or of two forward transactions (a so-called forward-forward swap). In a spot transaction the settlement or value date is usually two business days ahead for European currencies or the yen traded against the dollar. Thus if a London bank sells yen against dollar to a Paris bank on Monday, the London bank will turn over a yen deposit in Japan to the Paris bank on Wednesday and the Paris bank will transfera dollar deposit in US to the London bank on the same day. The time gap is necessary for confirming and clearing the deal through the communication network such as SWIFT. (Note that by the two business days ahead rule, deals done on Friday will have Tuesday of the following week as the value date if Saturday and Sunday are bank holidays as they are in most financial centres). To reduce credit risk (i.e. one of the parties failing to deliver on its side of the trade), both transfers should take place on the same day®. In the dollar-yen trade done on Monday, if the following Wednesday happens to be a bank holiday in either Japan or US, the value date is shifted to the next available business day, in this case Thursday. What about holidays in the dealing locations? If Wednesday isaholiday both in UK and France, settlement is again postponed to Thursday. Whatif Tuesday isa holiday in UK but not in France? Then “two business days” would mean Wednesday for the Paris bank but Thursday for the London bank. In such cases the normal practice is, if the Paris bank “made the market” ice. the London bank called for a quote, the value date would be Wednesday while if London made the market it would be Thursday. The settlement time is reduced to one business day for trades between currency pairs in the same time zone such as the US dollar and Canadian dollar and US dollar and Mexican peso*. Having understood value dates for spot transactions, let us look at value dates for forward transactions, In a 1-month forward purchase of say pounds against dollar, the rate of exchange is fixed on the transaction date; the value date is arrived at as follows: first find the value date for a spot transaction between the same currencies done on the same day and then add one calendar month to arrive at the value date. Thus for a one month forward transaction entered > The exception to this general principal is incase of Middle Eastern currencies because ofthe fact that in these countries Friday is a bank holiday while Saturday is not. Thus for a US dollar-Sauai riyal deal done on a Wednesday, the dollar deposit will be transferred on Friday while the transfer of riyals will be on Saturday. * Short dated transactions for delivery next day and “cash transactions” are also possible between other currencies 8a4 International Finance into on say June 20, the corresponding spot value date is June 22 and one month forward value date is July 22, two month forward is August 22 and so on. Standard forward contract maturities are 1,2,3,6,9 and 12 months. The value dates are obtained by aciding the relevant number of calendar months to the appropriate spot value date. If the value date arrived at in such a manner is ineligible because of bank holidays, then like in a spot deal, it is shifted forward to thenexteligible business day. However, there is one important difference, viz. rolling forward must not take you into the next calendar month, in which case you must shift backward. Thus suppose a 1-month forward deal is done on January 26. The spot date is January 28. One calendar month takes you to February 28. If February 28 is ineligible, you cannot shift forward because that goes into March (assuming it is not a leap year). It must be rolled back to February 27. ‘Though standard forward maturities are in whole number of months, banks routinely offer forward contracts for maturities which are not whole months. Thus a corporation can enter into a forward contract for delivery say 73 days from the date of transaction, Such contracts are called “broken date” or “odd date” contracts. For some currency pairs, long-dated forward contracts with maturities extending out to five years are available. ‘A swap transaction in the foreign exchange market is a combination of two transactions in opposite direction between the same two parties, the same pair of currencies but maturing at different points in time, A spot-forward swap consists of a spot transaction and a forward transaction in the opposite direction. Thus a bank will buy Euro spot against US dollar and simultaneously enter into a forward transaction with the same counterparty to sell Euro against US dollar. A spot-60 day dollar-euro swap will consist of a spot purchase (sale) of dollars against euro coupled with a 60-day forward sale (purchase) of dollar against Euro”. Ina forward~ forward swap, both transactions are forwards. For instance a 1 month-3 month dollar-euro swap may involve a one month forward purchase and three month forward sale of say one million dollars against euro, The uses of such transactions are discussed later in the chapter. As the term “swap” implies, itis a temporary exchange of one currency for another with an obligation to reverse it at a specific future date. Forward contracts without an accompanying spot deal are known as “outright forward contracts” to distinguish them from swaps. Itiias been estimated that about 65-70% of the turnover in the market is in the spot segment, 20-25% in swaps and the rest in outright forward contracts. Outright forwards are most often used by corporations to cover their exposures on account of import payables and export receivables. 35 2 XCHANGE RATE QUOTATIONS AND ARBITRAGE In foreign exchange literature one comes across a variety of terminology which can occasionally lead to unnecessary confusion about simple matters. You will hear about quotations in European Terms versus quotations in American Terms. The former are quotes given as number of units of acurrency per US dollar. Thus JPY 105.65 per USD, CHF 1.3500 per USD, INR 40.75 per USD are quotes in European terms. Quotes in American terms are given as number of US dollars per unit of a currency. Thus USD 1.2775 per EUR, USD 1.6542 per GBP are quotes in American 5 The amount of one ofthe two currencies is kept fixed. Thus ina dollar-curo swap, say a million dollars will ‘be bought spot and sold forward. The corresponding amounts of euros will depend upon the rates applicable to the spot and forward legs ofthe transaction. esThe Foreign Exchange Market 85 terms. The prevalence of this terminology is due to the common practice mentioned above of quoting all exchange rates against the dollar. You will occasionally come across terminology such as direct quotes and indirect quotes. (The latter are also called reciprocal or inverse quotes.) In a country, direct quotes are those that give units of the home currency of that country per unit of a foreign currency. Thus INR 40.5925 per USD is a direct quote in India but and USD 0.6385 per CHF is a direct quote in the US. Indirect or reciprocal quotes are stated as number of units of a foreign currency per unit of the home currency. Thus USD 2.4500 per 100 INR is an indirect quote in India’, Notice here that the “unit” for rupees is 100s. Similarly, for currencies like Japanese yen, quotations may be in terms of dollars or rupees per 100 yen. The notational confusion can get further compounded when we have to deal with two-way, bid-ask quotes for each exchange rate. ‘The inter-bank market uses quotation conventions adopted by ACI (Association Cambiste Internationale) which we will use in this book. These conventions are described below: Acurrency pairs denoted by the 3-letter SWIFT codes for the two currencies separated. by an oblique or a hyphen Examples: USD/CHF: US Dollar-Swiss Franc GBP/JPY: Great Britain Pound-Japanese Yen USD/INR: US Dollar-Indian Rupee USD-SEK: US Dollar-Swedish Kroner ‘The first currency in the pair is the “base” currency; the second is the “quoted” currency. ‘Thus in USD/CHF, US dollar is the base currency, Swiss franc is the quoted currency. In GBP/USD, British pound is the base currency, US dollar is the quoted currency. The exchange rate quotation is given as number of units of the quoted currency per unit of the base currency. Thus a USD/INR quolation will be given as number of rupees per dollar, a GBP/USD quote will be given as number of dollars per pound. ® A quotation consists of two prices. The price shown on the left of the oblique or hyphen is the “bid rate”, the one on the right is the “ask rate” or “offer rate”. The bid rate is the price at which the dealer giving the quote is prepared to buy—is “bidding for”—one unit of the base currency against the quoted currency. In other words, itis the amount of quoted currency the dealer will give in return for one unit of the base currency. The ask or offer rate is the price at which the dealer is willing to sell—is “offering” ~ one unit of the base currency. In other words it is the amount of quoted currency the dealer will want to be paid in return for one unit of base currency. Examples: USD/CHE Spot: 1.3550/1.3560 ‘The dealer will buy 1 USD and pay CHF 1.3550 in return. His “bid” rate for USD is CHF 1,3550, He will sell one USD and would wantto be paid CHF 1.3560 in return. His “offer” or “ask” rate for one USD is CHF 1.3560, GBP/EUR Spot: 1.3025/1.3035 Bid rate: Dealer will pay 1.3025 Euros per GBP when buying GBP (Offer rate: Dealer will want to be paid 1.3035 Euros per GBP when selling GBP. © Since August 21993, the interbank market in India has shifted to the direct method of quoting rates. Before that, indirect method was used. 3, FewIntemational Finance For most currencies, quotations are given in European terms, ie. the base currency is the US dollar. The major exceptions are EUR, GBP, AUD and NZD (New Zealand Dollar) ‘These are quoted in American terms, i.e. USD becomes the quoted currency against these. Inmarket parlance, a “cross rate” or just a “cross” is a quotation between two non-dollar currencies. Thus GBP/CHF is a “cross rate” and so is EUR/INR. In the US, financial press gives quotations in both European and American terms. ‘Quotations in inter-bank markets are usually given up to five or six significant digits or four decimal places. The last digit thus corresponds to (1/100)* of (1/100)"" unit of the quoted currency. Thus in the USD/CHF bid rate quoted above, viz. 1.3550 the last two digits, viz.“50" correspond to 0.0050 CHF. In the GBP/ EUR offer rate, viz. 1.3035 the last digit corresponds to 0.0005 EUR. ‘he last two digits ate called. "puis or “pipe”. The ditiecnce betwen the offer eae and the bid rate is called the "bid-offer spread” or the "bid-ask spread”. We say the bid- ask spread in the USD/CHF quote is ten points or ten pips. If the GBP/EUR rate moves 10 1.3028/38, we say the GBP has moved up three pips. For small denomination currencies like the JPY, quotes are given up to 2 decimals only—e.g. USD/JPY 105.65/105.85. In such cases a point or pip has the value 0.01 or (1/100)* of the quoted currency. ‘The quotations are usually shortened as follows: USD/CHF: 1.4550/1.4560 will be given as 1.4550/60. When two dealers are conversing with each other this may be further shortened to 50/ 60. The first three digits, viz. 145 are known as the “big figure” and professional dealers are supposed to know what the big figure is at all times. GBP/USD: 1.5365/72 means 1.5365/1.5372. ‘This may be further abbreviated to “65/72”. USD/INR: 41.4870/90 means 41.4870/41.4890 Remember that the offer rate—bank’s selling price—must always exceed the bid rate— bank's buying price—for any currency. Any bank will always want to make a profit on its currency dealing. Hence a quote such as USD/SEK 8.9595/10 must mean 8.9595/8.9610, The convention of denoting the currency pair as A/B when the rate is being given as number of units of B per unit of A can bea little confusing to those of us who are used to dealing with mathematical fractions in which A/B means amount of A divided by amount of B, ie. number of units of A per unit of B. With alittle care and practice the confusion is easily avoided. With these preliminaries let us examine in detail spot, forward and swap quotations and ir interpretation, Spot Quotations Arbitraging between Banks ‘Though one often hears the term “market rate”, itis not true that all banks will have identical quotes for a given pair of currencies at a given point of time. The rates will be close to each other but it may be possible for a corporate customer to savesome money by shopping around. Let us explore the possible relationships between quotes offered by different banks. 88The Foreign Exchange Market 87 1. Suppose banks A and B are quoting: A B 9 ——LASBO/LAS6O 1.4538 /1.4548 We will represent this as: Bank A. Bank B Obviously sucha situation gives rise to an arbitrage opportunity”. Pounds can be bought from B at $1.4548 and sold to A at $1.4550 for a net profit of $0.0002 per pound without any risk or commitment of capital, One of the basic tenets of modern finance is that markets are efficient and such arbitrage opportunities will be quickly spotted and exploited by alert traders. The result will be, bank B will have to raise its ask rate and/or A will have to lower its bid rate. The arbitrage opportunity will disappear very fast. In fact, in the presence of profit-hungry arbitragers, such an opportunity will rarely emerge in the first place. 2. Now suppose the quotes are as follows: A B 98 1.4550/1.4560 1.4545/1.4555 ‘These can be represented as: -[] Banka 1.4550 1.4560 o----- og Bank B 14545 1.4555 Now there is no arbitrage opportunity as in (1). Thus the two quotes must “overlap” by at least one point to prevent arbitrage. This means that the ask rate in one quote must be at least as high as the bid rate in the other. However, now bank A will find that itis “being hit” on its bid side much more often while B will find that itis confronted largely with buyers of pound sterling and few sellers. Aswe have seen above, from time to time a bank might deliberately move its quotes s0 as to encourage a particular type of transaction to rebalance its position. A corporation may thus shop around to get the best quotes. In practice, most corporations will not shop around to make a gain of a few points unless the amount involved is very large, Customers who flit from bank to bank in search of tiny savings often find that when it comes to executing a complex transaction, no bank is willing to give them the kind of service that it would give to its more ‘loyal’ customers. Nevertheless, itis a good idea to do some comparison shopping from time to time to keep the bank on is toes. 7 arbitrage in finance refers to a set of transactions, selling and buying or lending and borrowing the same asset or equivalent groups of assets, to profit from price discrepancies within a market or across markets. Mast often no risk is involved and no capital has to be committed. “Equivalent” in this context means having identical cash flows and risk characteristics. 088 International Finance Inverse Quotes and Two-Point Arbitrage Consider the spot quotation: USD/CHF: 1.4955/1.4962 Suppose this is a quote available from a bank in Zurich. At the same time, a bank in New Yorkis offering the following quotes: CHF/USD: 0.6695 /0.6699 1s there an arbitrage opportunity? Suppose we buy Swiss francs 1 million from the Zurich bank and sell them to the New York bank. For every dollar it buys, the Geneva bank will give CHF 1.4955. To buy 1 million CHF, will cost us $(1,000,000/ 1.4955), ic. $6,68,700. The Swiss francs bought from the Geneva bank can be sold to the New York bank at its bid rate of $0.6695 per franc for a total of $(0.6695 x 1000000), Le. $6,69,500. It seems we have made a profit of $800 with a couple of phone calls, no risk and no capital invested! Obviously, the CHF/USD rates implied by the Swiss bank’s USD/CHF quotes and the New York bank's CHF /USD quotes are out of line, Exhibit 3.1 illustrates, Exhibit3.1. Two-Point Arbitrage ‘$1 = CHF 1.4955, CHF 1 = $0.6695 ren ark New rk Bak | Give $668700 | ‘Take $669500 avec 1m Tate CHF 1 mon Recall that (CHE/USD),.is the rate that applies when the bank sells Swiss francs in exchange {for dollars. But this is precisely the deal we did with the Zurich bank and for each Swiss franc ‘we bought we had to pay $(1/1.4955) which is nothing but the reciprocal of the Zurich bank’s bid rate, ie. 1/(USD/ CHF). Thus (CHF/USD),q, rate implied by the Zurich bank's quote is nothing but the reciprocal of its (USD/CHF), quote. In the same way, the (CHF/USD),i. implied by the Swiss bank’s USD/CHF quotes is 1/(USD/ CHF). Implied (CHF/USD),,, = 1/(USD/CHF),,. Implied (CHF/USD),,, = 1/(USD/CHF),,. To prevent arbitrage, the New York bank 's (CHF/USD) quotes must overlap the (CHE/USD) quotes implied by the Swiss bank’s quotes. This means as we saw above that the New York ©de Exchange Market _ bank's CHF/USD ask rate must be at least as high as the CHF/USD bid rate implied by the Geneva bank’s quote. The CHF/USD quotes implied by the Zurich bank's USD/CHF quotes work out to 0.6684/0.6687. If the New York bank gives a quote such as 0.6686 /0.6689, it will not lead to arbitrage though it may lead to a one-way market for the banks. The rates actually found in the markets will obey the above relations to a very close approximation. Let us look at some further examples. Suppose a bank in London is quoting: GBP/USD spot: 1.5645/55 The implied USD/GBP rates are given by Implied (USD/GBP)iq = 1/(GBP/USD) ax = (1/1.5655) = 0.6988 Implied (USD/GBP),q, = 1/(GBP/USD)gia = (1/1.5645) = 0.6392 If some bank is quoting (USD/GBP): 0.6380/85 there is an arbitrage opportunity. Buy 1 USD at this bank's offer rate, viz. 0.6385. When you sell it to the London bank it will pay you GBP (1/1.5655) or GBP 0.6388. Your net profit is GBP 0.0008 per dollar; for a market lot of 10 million dollars the profit is $3000. (One more example. A bank in New York is quoting USD/ AUD: 1.8885/90 A Sydney bank is giving the following quote: AUD/USD: 0.5275/0,5280 Buy 20 million AUD against USD from the Sydney bank. It is selling AUD at its ask rate of USD 0.5280 per AUD. It would cost you USD (0.5280 x 20000000) or USD 10560000. Now sell the AUD 20 million to the New York bank. The New York bank is buying AUD —selling USD — atits ask rate of AUD 1.8890 per USD. You will get USD (20000000/ 1.8890) or USD 10587612.50. Your net profit isa little over USD 27000 with no risk whatsoever. The reason is the AUD/USD quotes implied by the New York bank’s USD/AUD quotes are: (1/1.8890)/(1/1.8885) = 0.5294/95 These lie completely outside the range of Sydney bank’s quotes. The picture is: @ New York AUD/USD 0.5294 295, Sydney AUD/USD The arbitrage transactions described above, viz, buying a currency in one market and selling itat ahigher price in another market iscalled “Two-Point Arbitrage”. Foreign exchange markets very quickly eliminate two-point arbitrage opportunities if and when they arise. Cross-Rates and Triangular Arbitrage A New York bank is currently offering these quotes: USD/JPY: 110.25/111.10 USD/ AUD: 1.6520/1.6530 Toacquire AUD against JPY in New York, you engage ina two-step transaction, viz. first sell JPY and get USD and then sell the USD to get AUD. o90 International Finance At the same time, a bank in Sydney is quoting AUD/JPY: 68.30/69.00 Is there an arbitrage opportunity? Consider this sequence of transactions: Sell yen, buy AUD in New York following the two-step process above and then sell the AUD so obtained against yen to the Sydney bank. ‘The calculations are: (Gubscripts N and S denote rates in New York and Sydney respectively). One yen sold in New York gets: USD[1/(USD/JPY) gq) = USD(/111.10) This amount of USD, viz {USD[1/(USD/JPY), 4} Sold against AUD gets AUD{[1/(USD/JPY),.,9](USD/ AUD), 499} = AUD (1/111.10)(1.6520). ) Finally the amount of yen obtained by selling the above quantity of AUD in Sydney is: ¥ {[1/(USD/JPY), 99 USD/ AUD),,495(AUD/JPY) ys) = ¥ (1/111.10)(1.6520)(68.30) = ¥ 1.0156 A riskless profit of ¥ 0.0156 per yen. ‘Thus 100 million yen sold against USD to the New York bank will get you ${100,000,000 x 0.0156] = $1.56 million A profit of 1.56 million yen with no risk at all and 100 million yen is a very small transaction by inter-bank standards. ‘Once again, the reason is that the AUD/JPY ctoss-rate implied by the USD/JPY and USD/ AUD rates in New York is out of line with the direct AUD/JPY rate quoted by the Sydney bank. No-arbitrage condition requires that having started with 1 yen you must not end up with more than 1 yen simply by buying and selling currencies at different locations: 1 (USD/IPY)asiang, IY aera USD erage AUD AUD a IPY (Here we have added the subscripts (N) and () to denote rates in New York and Sydney respectively, The reason for this will become apparent shortly.) The relation (3.1) can be re-written as follows: (USD/IPY) ier (AUD/JPY) siaesy $ {(USD/AUD hans But recall from our discussion of inverse rates that {1/(USD/ AUD) agg] = (AUD/USD) x@9) Hence inequality (3.2) implies (AUD/JPY apy £ (USD/JPY) 5% (AUD/USD),.0, (3.3) Or (AUD/JPY)piais) $ (AUD/TPY)asxeu x (USD/ AUD) aga) %(AUD/JPY) ag) $1 a) 62)n In deriving this we have treated currency quotes as if they were arithmetical fractions, This will become clear below. We have come across this above, When we have two quotes for the same pair of currencies, the ask rate in one must be at least as high as the bid rate in the other to prevent arbitrage. Now consider arbitrage in the reverse direction. Take a USD, buy yen in New York, sell yen for AUD in Sydney and sell AUD for USD back in New York. No arbitrage profit condition means that you should not end up with more than one dollar. This implies 1 1 OUP RI ass * TDA 64) Recall once again that 1/(USD/AUD) san * (AUD/USD) sian So that (3.4) can be rewritten as (AUD/JPY) gs) 2 (USD/JPY) pian) X (AUD/ USD) pide G5) Or, (AUD/JPY) says) 2 (AUD/JPY) iia) ‘Once again, the bid rate fora given currency against another in one quote must be no higher than the ask rate for the same currency in another quotation. Instead of New York and Sydney we could simply have imagined two banks quoting yen versus AUD, one giving rates directly while the other giving the rates derived from the USD/JPY and USD/AUD rates. The no- arbitrage conditions (3.3) and (3.5) simply give us upper and lower bounds on the direct rates in terms of the synthetic rates, To understand this clearly let us see how a synthetic pair of AUD/JPY quotes is derived. The synthetic (AUD/JPY)jie refers to a transaction in which the bank ends up with AUD and the customer with JPY. This can be viewed as the end result of two transactions: 1. Instep one, the customer sells AUD and buys USD. 2. Instep two, the customer sells USD acquired in step one and gets JPY. Starting with AUD1, the customer will get USD [1/(USD/AUD),a1] instep one; in exchange for this, in step two, the customer will get ¥ {[1/(USD/AUD) 4] x (USD/JPY)pia)- Thus Synthetic (AUD/JPY)yia = (USD/JPY)yia/[1/(USD/ AUD) 9.4] = (USD/JPY),ia x (AUD/ USD) ya G6) This works as if AUD/JPY, USD/JPY ete. were mathematical fractions: AUD _ USD, AUD JPY ‘JPY usD In the same way, we can have a synthetic (AUD/JPY),a, fate: Synthetic (AUD/JPY),a, = (USD/JPY) na, X (AUD/USD) a 67 Now notice that the right hand side of (3.6) is same as (3.5) and that of (3.7) is identical to that of (3.3). Thus the no-arbitrage conditions say that 692 International Finance Direct (AUD/JPY),ia S Synthetic (AUD/JPY),s, G8) Direct (AUD/JPY)sau 2 Synthetic (AUD/JPY ia 69) Diagrammatically, these inequalities mean that we cannot have either of the following situations: Synthetic 7 Bid Ask Direct Direct Ask This isa familiar condition. Whenever there are two sets of quotes for a pair of currencies, to prevent arbitrage they must overlap. The mechanics of working out synthetic quotes works no matter which way the two quotations are given, whether European terms or American terms or a mixture. Thus suppose we have: GBP/USD: 1.6545/1.6552 IEP/USD: 1.3655/1.3665 Then (CBP/IEP),.4 = (GBP/USD),,.; x (USD/TEP),.3 = (GBP/USD),iq x [1/(IEP/USD) a4) = (1.6545) (1/1.3668) = 1.2108 (GBP/IEP),, = (USD/IEP),5, x (GBP/USD) x. = [1/(IEP/USD),a] x (GBP/ USD). = (1/1.3685)(1.6552) = 1.2122 Synthetic (GBP/IEP): 1.2108/1.2122 If some bank is quoting GBP/IEP 1.2095/2105 there is arbitrage opportunity. Buy GBP from this bank spending IEP and then go through a two-step process, viz. sell GBP buy USD, and sell USD buy IEP, ending up with more IEP than you initially spent. If we have USD/CAD: 1.6505/1.6510 GBP/USD: 1.4524/1.4530 (GBP/CAD) aq = (USD/CAD) sq x (GBP/USD) ig (1,6508)(1.4524) = 2.3972 (GBP/CAD),4, = (USD/CAD), x (GBP/USD).q. = (1.6510)(1.4530) = 2.3989The Foreign Exchange Market 93 Synthetic (GBP/ CAD): 2.3972/2.3989 A quote such as GBP/ CAD 2.4250/55 will lead to arbitrage. ‘The term “three-point arbitrage” refers to the kind of transactions we described above. Start with currency A, sell for B, sell B for C and finally sell C back for A ending up with a larger amount of A than you began with. Efficient foreign exchange markets do not permit riskless arbitrage profits of this kind. This is an instance of the well-known maxim in economics, viz. there is no such thing as a free lunch. Notice that the synthetic cross rates between any pair of currencies X and Y, calculated from the rates of these two currencies against a third currency Z, impose only lower and upper limits on the rates a bank which is directly making a market between X and Y may quote. In other words, a situation like the following is perfectly acceptable: synthetic en direct In fact you must have realised that in computing the synthetic (GBP/CAD) rates, the bid- ask spreads in the (USD/CAD) and (GBP/USD) quotes are being compounded. A bank which specialises in making a CAD-GBP market can give direct quotes with narrower spread provided it has a sufficiently large volume of business in the two currencies, * Outright Forward Quotations Quotations for outright forward transactions are given in the same manner as spot quotations. ‘Thus a quote like: USD/CHF 3-Month Forward: 1.4570/80 ‘means, as in the case of a similar spot quote, that the bank will give CHF 1.4570 to buy a USD and require CHF 1.4580 to sell a dollar, delivery 3 months from the corresponding spot value date. Calculation of inverse rates and the notion of two-point arbitrage also carries over from similar calculations for spot rates. Given the above USD/CHF 3-month forward quotation, CHF/USD 3-month forward = [1/(USD/CHE),y1/{1/(USD/CHF},sal = (1/1.4580)/ (1/1.4570) = 0.6859/0.6863, Similarly, calculation of synthetic cross rates and the relation between synthetic and direct quotes to prevent three-point arbitrage are also same as in case of spot rates. Suppose we have: USD/INR 1-month forward: 40,2550/ 40.2565 USD/JPY 1-month forward: 101.45/101.60 ‘The implied cross-rate JPY/INR 1-month forward is: L-month forward (PY/INR)sia = (PY/USD)sia x (USD/INR) is = (1/101.60)(40.2550) = 0.3962 (PY/USD),., x (USD/INR).y (1/101.45)(40.2565) = 0.3968 ‘L-month forward (JPY/INR) qs, 6 rue94 International Finance Thus in general, given quotes for B/A and B/C the cross-rate C/A is to be calculated as: (C/A) sia = (C/B)ia (B/ Aa = [1/(B/ Ouse] X (B/ Ania (C/A)ask = (C/ Bask (B/A)asx = [1/(B/ pial * (B/ A) ack Keep in mind that the notation B/A means number of units of A per unit of B. Discounts and Premia in the Forward Market Consider the following pair of spot and forward quotes: USD/CHF spot: 1.5677/1.5685 USD/CHF 1-month forward: 1.5575/1.5585 ‘The dollar is cheaper—Swiss franc is more expensive—for delivery one month forward compared to spot dollar. The dollar is said to be at a forward discount in relation to CHF or, equivalently, the CHF is at a forward premium in relation to the dollar. With two-way quotations, there is no unique way to quantify the discount or premium. We can define the annualised percentage discount on dollar implied in the above quotations as: [forward (USD)/ CHF) ig ~ Spot (USD/CHF) nal x 19.499 Spot (USD/CHF) nig Here the subscript “mid” denotes the “mid-rate”, ie. the arithmetic average of the bid and offer rates. Forward (USD/CHF) a = (1.5575+1.5585)/2 = 1.5580 Spot (USD/CHE)qjq = (1.567741.5685)/2 = 1.5681 Hence the annualised forward discount on the dollar is _ (1.5580 - 1.5681) - 1.5681 In this formula, multiplication by 12 converts the monthly discount on dollar to annual discount and multiplication by 100 converts it into percentage terms. Strictly, weshould multiply by (360/N) or (365/N) where N is the number of days in the forward contract to annualise the premium, For instance if the one-month period consists of 31 days multiply by (360/31) = 11.6129, With this definition, for any quotation (B/ A), a negative answer would indicate that currency A (8) is ata forward premium (discount) vis-d-vis currency B (A) whereas a positive answer ‘would imply that A (B) is at a forward discount (premium). Consider another example. A bank is quoting (EUR/USD) Spot: 1.4050/60 91-Day Forward: 1.3885/0.3905 The forward and spot mid-rates are 1.3895 and 1.4055 respectively. The annualised premium on the dollar or discount on the euro is (1.3895 - 1.4055)/1.4055] (360/91)(100) = 4.50% In the last chapter we examined the relationship between forward premia/discounts and interest rate differentials in the offshore money markets. Inthe appendix to this chapter we 12100 = ~7.73% CIThe Foreign Exchange Market 95 will review it once more but now with bid-ask spreads both in the forex markets and the deposit markets. We will see that these “transaction costs” create a band of variation for the forward rate rather than a unique value. We will also examine some other types of arbitrage which influence the forward quotes in the presence of transaction costs. Margin Requirement When a forward contract is between two banks, nothing more than a telephonic agreement on the price and amount is involved, However, when a bank enters into a forward deal with a non-bank corporation, it will want to protect itself against the possibility that the firm may default on its commitment. (Remember that the bank will have squared its position by entering into an opposite forward contract with another party.) If the firm defaults, the bank must fulfil its commitment to that party possibly by buying the relevant currency in the spot market and the rates may have moved against the bank in the meanwhile. This is known as “reverse exchange rate risk”. If the firm has a credit line with the bank, the amount of the credit line will be usually reduced by the amount involved in the forward contract. Otherwise, the bank may ask the firm to deposit a certain percentage of the value of the contract with the bank or obtain some credit enhancement such as a guarantee from another bank. The deposit earns interest so there is no explicit cash cost. Sometimes, the bank may offer to deal in smaller amount than that asked for by the client. In an extreme case, the bank may decline to enter into a forward deal with a firm. + Swaps Swap Margins and Quotations Recall thata spot-forward swap transaction between currencies ‘Aand Bconsists of a spot purchase (sale) of A coupled witha forward sale (purchase) of A both against B. The amount of one of the currencies is identical in the spot and forward legs. Since usually there will be a forward discount or premium on A vis-a-vis B, the rate applicable to the forward leg of the swap will differ from that applicable to the spot leg. The difference between the two is the swap margin which corresponds to the forward premium or discount. Itisstated asa pair of swap points to be added to or subtracted from the spot rate to arrive at the implied outright forward rate. We will clarify this in detail shortly While banks quote and do outright forward deals with their non-bank customers, in the inter-bank market forwards are done in the form of swaps. Thus suppose a bank buys pounds ‘one month forward against dollars from a customer. It has created a long position in pounds (short in dollars) one month forward. If it wants to square this in the inter-bank market it will do it as follows: 8A swap in which it buys pounds spot and sells one month forward thus creating an offsetting short pound position one month forward. ® Coupled with a spot sale of pounds to offset the long pound position in spot created in the above swap. The reason for this is that itis very difficult to find counterparties with matching opposite needs to cover the original position by an opposite outright forward whereas swap position can be easily offset by dealing in the eurodeposit markets. Now let us see how outright forwards are derived from swap quotations. A typical swap quotation appears as follows: USD/CHF Spot: 1.6265/75 L-month Swap: 15/8 ote 96 International Finance How do we interpret this quote and get outright forward rates from this? In other words, at what rate will the bank buy/sell USD against CHE, delivery one month forward? First, the swap quotation is in “points”. It translates into CHE 0.0015 and 0.0008, To arrive at the implied outright forward, 0.0015 must be added to or subtracted from the spot bid and 0.0008 must be added to or subtracted from the spot ask rate. How do we know whether toadd or subtract in a given case? To arrive at an answer to this question, remember the following two principles: 1. The bank must always make profit, ie. the rate at which bank sells a currency must exceed the rate at which it buys the same currency. 2. Asageneral rule, the bid-ask spread widens as we go farther and farther into the future, Itis narrowest for spot, litle wider for 1-month forward, still wider for3-month forward and so forth. The reason is that the volume of turnover declines as maturity increases and also the default risk associated with forward transactions increases, In the above example suppose we add the swap points. We will have: USD/CHF 1-month forward: (1.6265 + 0.0015)/ (1.6275 + 0.0008) = 1.6280/1.6283. This violates the second principle above. Sometimes the mistake will be more obvious. For instance, ifthe spot quote had been 1.6265/1.6270, adding the swap points would have given us a forward quote of 1.6280/1.6278, which violates the first principle. Now take another example. We have the following quotes: EUR/SEK Spot: 9.1275/85 3-month Swap: 30/36 The swap points translate to 0,0030/0.0036. If we subtract, we get a 3-month forward of (0:1275-0.0000)/ (9.1285-0.0036) or 9.1245 /9.1249, which again violates the widening of spreads rule;if we add we get 10.1305/10:1321 which satisfies both the requirements (1) and (2) above. You will have noticed the difference between the two examples, In the USD/CHF case, the swap points were 15/8, a larger number followed by a smaller number; in the EUR/SEK case the swap points are 30/36, a smaller number followed by a larger number. We can state the following “mechanical” rule to compute outright forwards implied by a swap quotation: Spot rate (B/A) : Bid Rate for B/Ask Rate for B. Units of A per Unit of B If swap points are: Low/High Add swap points. A at Discount B at Premium, If swap points are: High/Low Subtract swap points. A at Premium B at Discount Remember that this rule is conditional upon our convention for quoting rates as (B/ A), viz. rates are given as units of A, the “quoted” currency, per unit of B, the “base” currency, bid followed by ask, bid is for the market-maker buying base currency B and ask is for the market- maker selling base currency B. ‘Another point is, which swap points are to be added or subtracted in a situation when the customer wishes to do a swap? Those on bid side or those on ask side? The answer can be made clear by an example. Suppose we have the following quote from a bank: oeThe Foreign Exchange Market 97 USD/ AUD Spot: 1.8560/70 2-month Swap: 15/20 A customer wants to do the following swap: The customer will sell US dollars spot and buy US dollars 2 months forward against Australian dollars. This means that in the forward leg of the swap, the bank will be selling the base currency US dollars; the relevant points to be added (added because small number followed by large number in the swap quote) are 20, on the offer or ask side of the swap quote. Thus the bank will do the forward sale of US dollars at premium of 20 points over the rate used in the spot leg of the swap. The premium on US dollar is against the customer. If the swap is the other way around, with customer buying spot US dollar and selling forward US dollar, ie. bank will be buying US dollars forward the points to be added are those on the bid side of the swap quote, viz.15, The bank will buy forward US dollars at a price 15 points above the rate used in the spot leg. Thus ina swap where bank sells forward, it collects a 20 point premium over spot whereas when it buys forward it gives only 15-point premium over spot. In effect, in giving the above quote the bank is saying that it is willing to swap either way (sell US dollars spot—buy forward or buy US dollars spot—sell forward) with the price in the forward leg being 15 points above the spat price if bank is buying US dollars forward and 20 points above the spot if bank is selling US dollars forward, Let us take another example. A bank is quoting: GBP/USD spot: 1.6570/75 3-months swap: 25/15 With swap points being big/small, points must be subtracted. This means that the base currency GBP is at a 3-month forward discount against the quoted currency USD. Here the bank is, in effect, saying: “We will buy GBP spot and sell 3-months forward at a discount of 15 points to the spot price or sell GBP spot and buy forward at a discount of 25 points on the spot price.” As usual, the market maker extracts a spread; gives a smaller discount when selling the base currency forward and demands a larger discount when buying it forward, Some more examples will help you gain a firm grasp of swap margins and quotations. Example 1: EUR/USD Spot: 1.3650/55 __ 3-month Swap: 12/8 3 Month Outrights: (1.3650 ~ 0.0012) (1.3655 ~ 0.0008) = 1.3638 /47 Bank will buy EUR spot, sell 3-month forward at a discount of $0.0008 below the spot rate; it will sell EUR spot buy 3-month forward at a discount of $0.0012 below spot Example 2: USD/INR Spot: 40.75/80 2-Month Swap: 12/20 2. Month Outrights: (40.75 + 0.12)/ (40.80 + 0.20) = 40.87/41.00 Bank will buy USD spot, sell 2-months forward ata premium of 20 paise over spot; sell USD spot buy 2-months forward at a premium of 12 paise over spot98 International Finance Example 3: GBP/USD Spot: 1.5760/65 6-month swap: 15/10 Find the 6-month outright USD/GBP quotes. 6-month outright GBP/ USD: 1.5745/55 6-month (USD/GBP) ys = [1/(GBP/USD) ,..] = 1/1.5755 = 6-month (USD/GBP)sy. = [1/(GBP/USD),i] = 1/1.5745 = 0.6351 Example 4: USD/INR Spot: 40.75/80 2-Month Swap: 12/20 USD/JPY Spot: 105.50/106.10 2-Month Swap: 20/15 Find INR/JPY 2-month outrights. USD/INR 2-month outrights: 40:87/41.00 USD/JPY 2-month outrights: 105,30/105.95 2-month (INR/JPY)g = (INR/USD)isq x (USD/JPY) a = [1/(USD/INR),s4] x USD/JPY).i4 = (1/41.00) x (105.30) = 2.5683 2month (INR/JPY)yq = (INR/USD)ya. X (USD/JPY)acx = [1/(USD/INR)pa] X (USD/JPY) ack = (1/40.87)(105.95) = 2.5924 The essence of a swap is the magnitude of the swap margin in relation to the spot rate. As we already know, this is closely tied with the interest rate differential. In fact in the inter-bank market when dealers trade forwards they are trading the swap margins or the interest rate differentials as we will shortly see. Interbank Forward Dealing Inter-bank forward deals are swap deals, The buyer isreally buying, the swap points, i, the interest rate differential and the spot riskis removed buy doing a spot deal in conjunction with the forward deal. A typical dialogue would go as follows: BANK A: “Bank A calling. Three-month yen-dollar please.” BANK B: “Twenty-five; thirty-five.” BANK A: “Fifteen dollars yours at twenty-five”. BANK B: “OK. Let's use a spot of 104.50 which is for value September 17; I buy at 104.75 for value December 17.” Bank A asks bank B for its 3-month forward quote between yen and dollars. Bank B quotes the swap points as 25/35. (Recall that a point in case of yen is 0.01 not 0.0001). Swap points are small/big so the base currency USD is at a premium. As seen above, this means that bank B will give a premium of 25 points if it is buying USD in the forward leg of the swap and will extract a premium of 35 points i itis selling USD forward. Bank A conveys that it wishes to sell forward 15 million dollars at a premium of 25 points. The remaining point is what is the spot rate to which this premium of 25 points is to be added? Bank B conveys that it will use a spot rate of 104.50, Is this the spot bid or ask rate in the inter-bank market? The answer is it may be neither; it will be very close to the actual spot quote. Bank B agrees to use a spot rate of 104.50 and immediately concludes a spot deal in which it sells fifteen million dollars spot at a price of 1104.50 yen per dollar 70 rarThe Foreign Exchange Market _ 99 ‘The reason for this is that the two dealers are really trading the yen-dollar interest rate differential. Bank B can hedge its position by borrowing USD, converting itinto JPY and investing JPY in the money market. Three months later, it uses the maturing JPY deposit to deliver on its forward contract, get USD and repay the USD loan. It would be paying a lower interest rate on the USD borrowing compared to the rate it would earn on the JPY deposit. This gain will be at the expense of the premium it has to pay on the forward dollar purchase. Bank B's decision to buy 3month forward dollars at a premium of 25 points would be justified only if this premium expressed as a percentage of the spot rate, annualised, is no larger than the interest rate differential®. In order to ix this, both the swap points and the spot rate must be fixed. Otherwise the dealer leaves himself open to the risk that the spot rate may move. ‘Now note that asa result of doing the swap, bank B hasa maturity mismatch, It must find 15 million dollars to deliver on the spot deal and will get in return delivery of ¥20325 million. It must “manage” this cash position unless its position before doing the deal was such that it was short spot yen and long spot dollar so that the spot part of the swap brings its inventories of the two currencies to desired levels. If not, it could do one of the two things: (@) Enter into an offsetting forward deal with say bank C in which it sells 15 million dollars S-months forward and buys spot. This will remove the maturity mismatch and square up its forward and spot positions. fit can locate a counterparty which will deal at swap points 25/35, it will earn 10 points, ie. 0.10 yen per dollar or a total gain of ¥1.5 million. However, keep in mind that the spot could have moved before doing such an offsetting deal. In this case there will be a residual cash position’. Also it would be a rare event to find a counterparty whose needs exactly offset the position of Bank B. () Alternatively, Bank B can roll forward its position by a series of overnight swaps. Recall that due to its swap with bank A, it hasa short position in dollars and a long position in yen both for spot value date. It can do a spot-next swap in which it buys dollars against yen value spot date and sells dollars against yen value the day after the spot date. It has rolled its spot position one day forward. Since the yen is at a forward discount it will gain some points in this roll over, equal to the difference in interest earning on an overnight dollar deposit and an overnight yen deposit. It can keep rolling its position from one day to the next till the maturity of the original forward done with bank A. Provided the total number of points it gains on such rollovers is more than the number of points premium it has paid in the original swap, ie. 25 points, it will have made a gain. There is however one small problem. Each of the overnight swaps will be done off a spotrrate different from the spot rate in the original swap; hence small cash positions in yen will arise, Also, how many points it will gain in each overnight swap is uncertain. (©) As discussed above, it borrows dollars and invests yen to manage its cash position The inter-bank forward market is really a market for duplicating the money market lending- borrowing transactions via the currency market. Thus the traders must monitor interest rate ® Suppose the interest rate differential is smaller, then Bank B has allowed Bank A to make covered interest arbitrage at its own cost; conversely if itis larger, Bank A has allowed arbitrage against itself * Thus suppose it sels forward to bank C ata discount of 25 points but the accompanying spot purchase is done not at 104.50 but 104.52. It has thus a shortage of ¥(0.02 x 150KK0000) = ¥300,000 in its spot position ‘which it must carry for 3 months. The interest cost of this will partly offset the gain. "| i | | le 100 International Finance differentials and attempt to guess how these interact with the spot rate. A movement in spot rate after a forward deal is done (accompanied by its companion spot deal), will change swap points for a given interest rate differential but may also affect the interest rate differential, As we have seen above, spot rate movements also give rise to temporary short and long positions in different currencies and hence interest expenses and earnings. This is the “spot risk” in forward transactions. Itis possible to create hedges for a part of this risk but the effectiveness of the hedge is difficult to judge because of the complex interrelationships between spot rate, forward rate and interest rate differentials" . See Bishop and Dixon (1992) for examples of how dealers hedge spot risk in forward transactions. Inthe case of some currencies with restricted capital account, a transaction known as Non deliverable forward is available. Here the full amounts of the two currencies are not exchanged at contract maturity; only the difference between the contract rate and the spot rate at maturity is settled ina convertible currency suchas US dollar. Thus suppose a firm enters into a 90-day non- deliverable forward contract to buy US dollars 500,000 against the rupee at the rate of Rs 41.00; at maturity the spot rate is Rs 40.80. The firm must pay the bank US dollar equivalent of: Rs [500000 x (41.00 - 40:80)] = Rs.100000, ‘The US dollar equivalent of this rupee amount has to be calculated at the spot rateat maturity, in this case Rs 40.80 per dollar. Thus the payment would be: ‘USD(100000/40.80) = USD 2450.98, ‘The NDE contract is discussed in greater detail in the appendix to this chapter. Forward-Forward Swaps The swaps we have looked at so far are spot-forward swaps. It is possible to do a swap between two forward dates. For instance, purchase (sale) of currency A 3-months forward and simultaneous sale (purchase) of currency A 6-months forward, both against currency B, Such a transaction is called a forward-forward swap. It can be looked upon as a combination of two spot-forward swaps: 1. Sell A spot and buy 3-months forward against B 2. Buy A spot and sell 6-months forward against B In such a deal, both the spot-forward swaps will be “done off” an identical spot rate so that the spot transactions cancel out. The customer (and the bank) has created what is known asa swap position —matched inflow and outflow in a currency but with mismatched timing, with an inflow of A three months hence and a matching outfiow six months hence. The gain/ loss from such a transaction depends only on the relative sizes of the three-month and six-month swap margins. Some Applications of Swaps As mentioned above, banks use swaps amongst themselves to offset positions created in outright forwards done with customers. You may have noticed that a swap deal alters the timing of cash flows. A firm with uncertain timing of foreign currency payables or receivables may use swaps as an alternative to option forwards (see below). For instance, suppose a firm bought CHF forward against dollar 3-months forward on August 30, 1 Recall from the text that the covered interest arbitrage relation which appears to be quite simple, is not a «causal relationship. All the three variables involved in it are simultaneously influenced by fundamental factors like monetary policy, BOP developments and expectations. R FueThe Foreign Exchange Market 101 The delivery date is December 1, By late November, it realises that it does not need the CHF on December 1 but on December 14. On November 29 it can do a swap ~ sell CHE spot and buy it for delivery on December 14. The CHE received from the original forward contract is used to deliver against the spot leg of the swap. ‘Another application of swaps is in the so-called “Roll-Over Forward Contracts’. In some countries, forward markets do not exist beyond certain maturities. For example, in India at one time forward transactions beyond six months were not possible. Consider the case of a firm which has contracted a foreign currency loan of $1,000,000, The principal has to be repaid in ten six-monthly instalments starting six months from today. Ignoring the interest payments (which can be easily figured into the calculations), the firm has definite outflows of $100,000 every six months for the next five years. The firm would like to know the rupee value of its entire liability at all times, However, it cannot buy dollars more than 6-months forward at any time. Itcan use swaps as follows: ® Buy $1,000,000 6-months forward at a rate known today. © Sixmonths ater, take delivery, use $100,000 to repay the first instalment. For the remaining, $900,000, do a 6-month swap—sell in the spot market, buy 6-months forward. Rupee outflow six months later is again known with certainty. ® Repeat this operation every six months till the loan is repaid. Forward-forward swaps can be used to speculate on interest rate movements (rather movements in interest rate differentials) with minimal exchange rate risk. They can also be used to lock-in the forward margin between two future dates. We will ook at examples of these. SWAP POSITIONS: Speculating on Interest Rate Movements As the following example illustrates, a forward-forward swap can be used to takea view on interest rate differentials with a minimum of exchange rate risk. ® A treasurer finds the following rates in the forex market: £/$ Spot: 1.7580/90 ‘L-month: 20/10 2-months: 30/20 3-months: 40/30 6-months: 40/30 12-months: 30/20 US interest rates are somewhat below UK rates but less so at the far end, The treasurer is. confident that in six months, UK rates are going to fall, and the sterling will go into a forward premium. He expects the 6-month swap points to become 100/200 in six months time, How can he profit from this forecast? 1. Outright Speculation: Buy 12-months forward sterling 5 million at $1.7570. Six months later, after sterling has gone to premium, sell 6-months forward sterling. Suppose the rates then are: GBP/USD spot: 1.7585/95 6-months: 40/60 He can sell 6-months forward at 1.7625, This represents a gain of $0,0055 per sterling (transaction costs will reduce this somewhat) or $27,500 for 5 million sterling. The risk 8102 International Finance of course is that the sterling may depreciate in the meanwhile. Suppose the spot rate goes to 1.7000/05 then even with a premium on 6-month sterling he will lose since he will have to sell at 1.7040. 2. Creating a Swap Position: On day 1, 0, do two swaps, viz. buy sterling spot and sell 6-months forward and sell sterling spot, buy 12-months forward, Essentially a forward-forward swap has been done—sell 6-months forward and buy 12-months forward. The spot leg in the two swaps cancels out. Suppose both the swaps are done off a spot rate of 1.7580. In the first the discount against the treasurer is 40 points; in the second, the discount in his favour is 20 points, Thus the following cash flows will occur at {= 6 months and = 12 months from now: i= 6 Months £=12 Months (Gell £ buy $) (Buy £ sell $) ~£5,000,000 + £5,000,000 + $8,770,000 - $8,780,000 (© 5000000 x 1.7540) (= 5000000 x 1.7560) Six months later, suppose the treasurer's forecast has materialised to an extent. Sterling has gone to a premium but not to the extent forecast. The rates are: GBP/USD spot: 1.7000/1.7005 6-months: 80/160 Now execute another swap, viz. buy £5 million spot and sell six months forward. Suppose the spot rate is 1.7005 and the swap margin will be 80 points premium on sterling. The resulting, cash flows are: £=6 Months ¢=12 Months (Spot purchase of &) (Swap done at 6 months) ++ £5,000,000 ~ £5,000,000 ~ $8,502,500 + $8,542,500 Combine these with the cash flows resulting from the swap done at t= 0: = 6Months t= 12 Months ~ £5,000,000 +£5,000,000 : + $8,770,000 ~ $8,780,000 Swap done at = 0 + £5,000,000 ~ £5,000,000 i ~ $8,502,500 + $8,542,500 Swap done at ¢= 6 Net: + $267500 ~ $237500 With all the transactions taken together, we have a net gain of $30,000 (ignoring the interest received on the net inflow of $267,500 at six months). Suppose instead that the sterling had appreciated between time 0 and six months to say 1,8000/1.8010. We continue to assume that the interest rate forecast has materialised so that 6-month swap points are 80/160. Now at six months, sterling is bought spot at 1.8010 and sold 7% rast—_____is Frain Exchange Market 0 6-months forward at 1.8090. You ean check that there will be a loss of $2,35,000 at six months and a gain of $2,65,000 at twelve months, with an overall gain of $30,000 once again. Note that by crea.'ng this swap position, the treasurer is speculating on the interest rate differential. The risk of spo. exchange rate is eliminated. If the interest rate forecast turns out to be wrong, e.g. ifsterling interest rates increase so that sterling goes further into discount, a loss will be incurred. Thus if the spot moves to 1.8000/1.8010 as above but 6-month swap points are 60/40, there will be a loss of $2,35,000 at six months and a gain of only $1,95,000 at twelve months producing anet loss. Swaps can also be used to lock-in a spread between two future dates. Suppose at the end of August the USD/INR rates in the Mumbai market are: Spot: 40.60/70 2-months: 20/30 S-months: 40/70, We do two spot-forward swaps, both off a spot rate of 40.65. Buy spot sell October at (40.65 + 0.20) = 40.85 Sell spot buy January at (40.65 + 0.70) = 41.35 Effectively, we have locked in the October-January spread at 50 paise. We will see an application of such a deal ina later chapter when a corporate treasurer wants to take a view on the spot rate but wishes to lock-in a swap margin. We will now examine how banks use swaps to simulate lending, borrowing and vice-versa. ‘Swaps and Deposit Markets At various places we have stated that banks arbitrage between foreign exchange swap markets and the money markets such as the Eurodeposit market. What does this mean? One straightforward meaning is that the banks will constantly monitor its swap rates so that they are not out of line with the forwards implied by the interest rate differentials in the money market. A bank cannot make arbitrage profits at the expense of another nor should it permit another bank to make riskless gains at its own expense. ‘We have seen that a foreign exchange swap is like a temporary exchange of one currency for another—you give say dollars and take Swiss francs today with a commitment to take back dollars and give back Swiss francs at a future date. In this sense itis quite similar toa combination of lending a currency and borrowing another. In fact a bank can “manufacture” a swap quote from Eurodeposit rates or manufacture a Eurodeposit rate from swap quotes, We will look at two examples to illustrate this. © Suppose a customer approaches a bank for a 3-month CHF-NOK (Norwegian kroner) swap. The customer will sell CHF 1 million spot against NOK and buy CHF 1 million 3-months forward against NOK. At the time, the forward markets in NOK are very thin and volatile. There is however a market in EuroNOK deposits. The rates are as follows: CHE/NOK Spot: 5:3040/45 EuroCHF 3-month:3-3% — EuroNOK 3-month: 5-54 What swap margin should the bank quote? Assume that the swap is done off a spot rate of CHF/NOK 5.3042. The bank borrows NOK 5.3042 million at 542% and delivers it to the customer. It invests the CHF 1 million received from the customer at 3%, Teas104 Imernational Finance Upon maturity, the bank must repay: NOK 5.3042 (1 + 0,25(0.0550)] million = NOK 5377132.75 Its CHF deposit will have grown to: CHFf1 + 0.25(0.03)] million = CHF 1007500 ‘The bank will break even if on the forward leg of the swap" it charges a rate of: (6377132.75/1007500) = 5.3371 NOK per CHF ‘The bank has thus “manufactured” a swap quote from the interbank deposit markets. * Now consider another situation. A customer approaches a bank with a request for a 3-month loan of DKK 50 million. At the time there is no active Euromarket in Danish Kroner. There are however active spot and forward USD/DKK markets. The bank can cater to the customer's needs by doing the following: (1) Borrow dollars Q) Doa USD-DKK 3 month swap, ie. sell dollars spot. Against DKK and buy dollars 3-month forward and @) Loan the DKK to the customer. The rates available to the bank are as follows: Spot USD/DKK: 8,5025/35 3-month swap: 350/400 Eurodollar 3-month rates: 8:-8% ‘What interest rate should the bank quote on the DKK loan? Suppose the bank can do the swap at a spot rate of 85030 and a swap margin of 400 pips. Thus on the forward leg it will have to pay DKK 8.5430 per USD. To buy DKK 50 m in the spot market to give the loan it must borrow: USD (60/8.5030) million ‘At maturity, ithas to buy back the same amount of dollars ata rate of DKK 8.5430. In addition it has to pay interest on the dollar loan which it must buy forward outright. The amount of, interest is: $ (60/8.5030){0.25(0.0875)] and the outright forward USD/DKK rate is 8.5435. The total amount of Danish kroner the bank must recover from the customer is therefore: (60/8.5030)[8.5430 + (0.25)(0.0875)(8.5435)] million = DKK 51.3342 million. Hence the breakeven rate of interest is: 4 x [(61.3342/50) - 1] = 0.1067 = 10.67% In this example, the bank has “created” a EuroDKK deposit using the foreign exchange markets and the Eurodollar market. ‘These examples illustrate how banks arbitrage between deposit markets and foreign exchange 1% Actually there is a small complication. The customer will buy back CHF 1 million and pay NOK 5337100. ‘The remaining amount NOK 40032.75 must be bought in the outright forward market. The bank will have ‘a surplus of CHF 7500. Thus it must get the breakeven rate on the outright forward too. 76The Foreign Exchange Market 105 markets using the principle of covered interest arbitrage. Now you can also understand why banks offset positions created by an outright forward transaction by means of a spot and a swap. Banks can easily simulate a swap by lending and borrowing in the Euro money markets. Option Forwards A standard forward contract calls for delivery ona specific day, the settlement date for the contract. Forward contracts wherein one of the parties has an option to make or take delivery on any day within a specified interval are known as option forward contracts or option forwards, Here, the contract is entered into at some time fy with the rate and quantities being fixed at this time but the buyer has the option to take or make delivery on any day between fy and fy with fy > t, > fy. Thus a 6-month option forward with option period from end ofthree months to end of six months allows the contract buyer the privilege to settle the contract anytime between end of 3 months from now to end of 6 months from now. In pricing these contracts, banks assume that the customer will ask for settlement at a time (during the option period) most advantageous from the customer's point of view. ‘We will clarify with some examples, ®& Ona particular day the following rates are ruling in the market: USD/CHE spot: 1.1200/10 3 months: 75/65 6 months: 125/110 At both 3- and 6-months swap points are big/small and hence to be subtracted. The 3-month and 6-month outright forward rates are 3 months: 1.1125/45 6 months: 1.1075/1.1100 ‘The CHF is at a premium both for the 3-month and 6-month maturity. Suppose the customer wants to sell CHF 3 months forward with delivery option period being from the spot value date to three months. In this case the bank will give the customer the least possible premium over the option period, i.e. the bank's offer rate for dollars will be the spot offer rate, viz.1.1210. Ifthe customer wanted to buy CHE, the bank will charge the largest possible premium over the option period. Iis bid rate for dollars will be the 3 month forward bid rate, viz. 1.1125. For a 6-month forward contract with option period from 3 to 6 months (i. delivery on any day after 3 months but before 6 months) the bank's bid and offer rates for the dollar would be: (USD/CHP)yig: 1.1075 (USD/CHP),y, = 1.1145 ie. when bank sells CHF (buys $) it will charge the 6-month premium but when it buys CHF (cells dollars) it pays only the 3-month premium. ® The following USD/EUR rates are observed in the market, EUR/USD Spot: 12710/15 3 months: 20/30 6 months: 40/60 The corresponding outright forwards are: 3 months: 1.2730/45 6 months: 1.2750/75 7 risele 106 International Finance Euro is at a forward premium for three as well as 6-months. Now, when bank sells EUR it will take the maximum possible premium and when it buys EUR it will give the least possible premium. Its EUR/USD bid and ask rates for 0-3 month and 3-6-month-options are as follows: 0-3 months 3-6 months (EUR/USD) ia 1.2710 1.2730 (EUR/USD) xg, 1.2745 1.2775 ® The Danish Kroner-U-S dollar rates are as follows: USD/DKK Spot: 4.1920/30 3 months: 100/200 6 months: 150/50 The kroner is at discount for 3-month forwards but at a premium for 6-month forwards. ‘The outright forwards are 3 months: 4.2020/4.2130 6 months: 4.1770/4.1880 Applying the same principle we get the following rates: 0-3months 3-6 months (USD/DKK),i3 4.1920 4.1770 (USD/DKK)si 4.2130 4.2130 ‘Thus when bank sells DKK with 0-3-month option period, it does not give any discount; for 3-6-month option period it charges the 6-month premium. When it buys DKK, it takes 3-month discount in the former case and also in the latter case. Option forwards are an attempt to combine features of a standard forward contract and an option contract. The party who gets the option to deliver prematurely over a sub-period of the life of the contract has to pay for this timing option, Banks recover this payment by charging the rate most favourable to them as seen above, 3.6 = SHORT-DATE AND BROKEN DATE FORWARD CONTRACTS. + Short-Date Contracts We have seen above that the normal value date for a spot transaction is two business days ahead. It is possible to deal for shorter maturities, i.e. value same day or value next day in currencies whose time zones permit the transaction to be processed. For instance, itis possible to doa £/$ deal for delivery same day because the five-to-six hour delay between New York and London allows instructions to be transmitted to and processed in New York. A $/¥ deal for same day value would not be possible because by the time New York opens for business, Tokyo is closed Short date transactions are those in which value date is before the spot value date’, Pricing of such contracts is again based on interest rate differentials and involve one-day swaps. We will not discuss the technical details here. The interested reader can consult Apte (2008) among others. 8The Foreign Exchange Market 107 + Broken Dates We have seen that banks normally quote forward rates for certain standard maturities, viz. 1,23, 6,9 and 12 months, However, they offer deals with any maturity, e.g. 47 days or 73 days etc. which is not in whole months. Such deals are called broken date or odd date deals, Rates for such deals are calculated by interpolating between two standard dates. ‘Thus suppose today is September 7, the spot date is September 9 and we have: GBP/USD Spot: 1.7075/80 2 months: 45/35 3 months: 120/110 We wantthe bid rate for £ for November 19. This is 2 months and 10 days from the spot date. ‘The premium on USD over the third month is (120 ~ 45) = 75 points, and there are 30 days between November 9 and December 9. This is distributed pro-rata over 30 days to get a pet day premium of 2.5 (= 75/30) points. For ten days, the premium would be (10 x 25) = 25 points, This is added to the two-month premium to give a total premium of 70 points between September 7 and November 19. The outright bid rate would thus be (1.7075 - 0.0070) = 1.7008. Consider another example. In the Mumbai market the following rates are seen on April 3: Spot USD/INR: 40.75/80 Spot-End April: 5/8 Spot-End May: 12/17 Spot-End June: 20/30 Let us compute the outrights for June 17. On the bid side, between end May toend June, ie. cover 30 days, the discount on the rupee rises by 8 paise. For 17 days from end May to 17 June, the discount would rise by [(17/30) x 8] paise or 4.53 paise. On the ask side it would rise by [(17/30) x 13] paise or 7:37 paise. ‘The end-May outrights are 40.87/97. The 17 June outrights would be (40.87 + 0.0453) or 40.9153 and ask would be (40.97 + 0.0737) or 41.0437. This can be rounded off to 40.91/41.04. Keep in mind however that interpolating in this manner hasa drawback. Ifthe dates between which you are interpolating are far apart this procedure can produce serious errors, Thus interpolating an eight-month rate from a six-month and a nine-month rate is not proper. The reason for this is that, as we know, the spot forward margins are related to the relevant interest rate differentials and these can be very volatile. Also note that interpolation assumes that the monthly swap margin can be evenly spread over the days in the month. However, due to special conditions (e.g, bank reporting days, tax payment days etc.) one-day swap margins may not be identical throughout the week. In such cases, special adjustments are needed. These technical matters are best left to professional currency traders, “ORWARD RATE AS RISK-ADJUSTED FUTURE SPOT RATE A forward contract entered into at a rate quoted in the market at the time is a “zero-cost” contract, ie. neither party pays anything to the other up-front. They only exchange two promises to pay in the future rather like an exchange of two promissory notes. Suppose a firm buys say "2 This isa strict definition of short date, More loosely, short dates reer to maturities less than a month,108 International Finance 1 million US dollars 90 days forward at a market rate of CHF 1.3550 when the spot rate is 1.3725. At the time the contract is entered into two promises are exchanged: the bank promises to pay USD 1 million and the firm promises to pay CHF 1.3550 million both payments to be made on the settlement date. Thus both parties agree that the present value of USD 1 million to be paid 90 days from now equals the present value of CHF 1.3550 million also to be paid 90 days from now. What is the basis of this equivalence? ‘We know that the spot rate USD/CHF ninety days from now is uncertain; itis a “random variable” in statistical language. At least in theory, it could be as highas say 3.00 CHF per USD or as low as 1.05 CHF per USD. Of course you might say that the probability of such extreme values is very low; but how about a rate of say 1.15 or 2.50? A bank which agrees to sell dollars at a rate of 1.3550 runs the risk of a huge loss if the actual rate turns out to be 2.50 and stands to make a large profit if itis 1.15; conversely the firm risks a large loss if the rate is 1.15 and will gain if itis 2.50, Still both seem to agree that pv) = PVE, 1) where the "~" over Sy indicates that itis a random variable, F,, - denotes the forward rate at time t (now) for delivery at time T (say 90 days later) and PY denotes present value. There is no uncertainty about F,,. This implies that the market forward rate at time t in contracts maturing at time 7, is the “risk-adjusted certainty equivalent” of the uncertain spot rate at time T. To convey the intuition underlying the concept of certainty equivalence suppose you are offered the following lottery: “A fair coin will be tossed; if it comes up heads, you will get Rs 1 lakh. If tails you will get nothing.” The “expected value" of this lottery is Rs 50000. You will win 100000 with probability 0.50 and nothing with probability 0.50. Suppose instead that you are offered a certain sum of money without any risky gamble. How much would be “as good as the lottery” in your view? That is your personal “certainty equivalent” of the uncertain outcome of the lottery. You are willing to exchange that certain sum of money in return for giving up the lottery. ‘The “market” is willing to exchange the forward rate F,, in return for the uncertain spot rate. Itis the market's certainty equivalent of the uncertain spot rate at time T. This has implications for valuation of future cash flows in foreign currency, for reporting forward contracts, and for choosing budget rates for various purposes. Consider an Indian firm which has a 180-day USD 250,000 receivable. Assume that there {sno risk of default by the counterparty. How should it be valued today? One possibility is to translate the USD amount into Indian rupees at the spot rate expected after 180 days and then discount at a discount rate that reflects the exchange rate risk py = HS:)<250000 i) : Here r* represents an annualised discount rate that reflects the exchange rate risk. The trouble with this is that itis not clear how to obtain an estimate of the expected spot rate and how to adjust the discount rate for exchange rate risk. Alternatively, the firm could translate into home currency at the 6-month forward rate being quoted in the market and discountat the risk-free rate, e.g. treasury bill rate. Remember that the firm could ensure its ”The Foreign Exchange Market 109 rrupee cash flow by selling the receivable forward. Thus, an alternative valuation would be: 1250000 14H) sa) where ris the risk-free interest rate. In the same vein, an outstanding forward contract should be valued and reported at its current market value. In the appendix we discuss the topic of valuing “old” forward contracts, i.e. forward contracts entered into some time inthe past, at the then market forward rates and which are yet to mature. Finally as we will see in Chapter 7, the market forward rate is the correct budget rate to use to assess hedging performance. In practice, accountants usually value and report outstanding foreign currency items at the current spot rate. On settlement a capital gain or loss is reported. EXCHANGE RATE REGIMES AND THE FOREIGN EXCHANGE MARKET IN INDIA + Exchange Rate Regime and Exchange Control The exchange rate regime in India has undergone significant changes since independence and there is a steady trend towards greater liberalisation. During 2006, regulations governing booking of forward contracts based on past export/import performance and those governing foreign currency remittances by residents were further liberalised. The April 2007 Annual Policy Statement of RBI announced that Small and Medium Enterprises (SMEs) will not be required to produce evidence of underlying exposures or past records of imports or exports to book forward contracts. Similarly, resident individuals will be permitted to book forward contracts up to an annual limit of USS 100,000 without producing underlying documents. Remittance of foreign exchange for various corporate purposes such as payment of consultancy fees for infrastructure projects or corporate donations for specified purposes have also been liberalized. ‘The reader should consult RBI's Annual Policy Statements to keep track of changes in regulation governing the functioning of the foreign exchange market. Full convertibility on current and capital accountsis expected to be in place in the near future. Some of the liberalisation measures implemented in recent times are as follows: (a) Authorised dealers are permitted to initiate trading positions, borrow and invest in overseas market, subject to certain specifications and ratification by respective banks’ Boards, (0) Banks are also permitted to: 1. Fix net overnight position limits and gap limits (with the Reserve Bank formally approving the limits); 2. Determine the interest rates (subject to a ceiling) and maturity period of FCNR(B) deposits with exemption of inter-bank borrowings from statutory preemptions; 3. Use derivative products for asset-liability management. (©) Participants in the foreign exchange market, including exporters, Indians investing abroad, and Fils are now permitted to avail forward cover and enter into swap transactions without any limit, subject to genuine underlying exposure. (A) Fllsand NRis are permitted to trade in exchange-traced derivative contracts, subject to certain conditions, nse0 International Finance _ (©) Foreign exchange earners are permitted to maintain foreign currency accounts, Residents were permitted to open such accounts within the general limit of US $25,000 per year, which was raised to US $50,000 per year in 2006, has further increased to US $1,00,000 since April 2007. ( Limits on overseas direct and portfolio investments by Indian companies have been. significantly liberalised. ‘Throughout this period the RBIhas administered a very complex system of exchange control, The statutory framework was provided by the Foreign Exchange Regulation Act (FERA) of 1947 which was amended in 1973, 1974 and 1993. It has been replaced by Foreign Exchange Management Act (FEMA) of 1999. Even a summary treatment of its myriad provisions and historical evolution would require a book-length study. Further, exchange control regulations are liable to be changed frequently. Consequently we cannot present more than a cursory discussion of the key ingredients which have a bearing on the workings of the foreign exchange market in India, For further details, the interested reader should consult the latest edition of, the Exchange Control Manual which is available on the RBI website and the subsequent exchange control announcements also available there and published in RBI’s Monthly Bulletin. The following few paragraphs taken from the RBI notifications pertaining to FEMA summarise the broad framework of exchange control. “ Application of FEMA may be seen broadly from two angles, viz.,capital account transactions and current account transactions. Capital account transactions relate to movement of capital, ‘eg. transactions in property and investments and lending and borrowing money. Transactions which do not fall in capital account category are current account transactions which are permitted freely subject to a few restrictions as given in the following paragraph (@) Certain current account transactions would require RBI permission if they exceed a certain ceiling. (b) A few current account transactions need permission of appropriate Government of India authority irrespective of the amount, (©) There are seven types of current account transactions which are totally prohibited and no transaction can, therefore, be undertaken relating to them, These include transactions relating to lotteries, football pools, banned magazines and a few others.” “Some other highlights of the new Act are: The Foreign Exchange Management Act and rules give full freedom to a person resident in India who was earlier resident outside India to hold or own or transfer any foreign security or immovable property situated outside India and acquired when he/she was resident there. ® Similar freedom is also given to a resident who inherits such security or immovable property from a person resident outside India, ® A person resident outside India is permitted to hold shares, securities and properties acquired by him while he/she was resident in India. ® A person resident outside India is also permitted to hold such properties inherited from a person resident in India. ® The exchange drawn can also be used for purpose other than for which it is drawn provided drawal of exchange is otherwise permitted for such purpose, russ_The Foreign Exchange Market m ‘8 Certain prescribed limits have been substantially enhanced. For instance, residents now going abroad for business purposes or for participating in conferences/seminars will not need the Reserve Bank's permission to avail foreign exchange up to US $25,000 per trip irrespective of the period of stay; basic travel quota has been increased from the existing US $3,000 to US $5,000 per calendar year. The Exchange Earners’ Foreign Currency (FEFC) account holders and Residents’ Foreign Exchange (RFC) account holders are permitted to freely use the funds held in EEFC/ REC accounts for payment of all permissible current account transactions.” (All exporters are allowed to retain up to 50% of their export earnings in BEFC accounts, Some categories of exporters are allowed up to 70%.) ® “The rules for foreign investment in India and Indian investment abroad are also comprehensive, transparent and permit Indian companies engaged in certain specified sectors to acquire shares of foreign companies engaged insimilar activities by share swap or exchange through issue of ADRs/GDRs up to certain specified limits.” Foreign currency financing by Indian companies by way of bank loans and bond issues and other capital account transactions require advance approvals from the Government and/or RBI. Investment by non-residents in India are also subject to a variety of regulations. A list of capital account transactions by residents and non-residents coming under the purview of these regulationsis given in the appendix to this chapter. However, keep in mind that these regulations are subject to continuous change and hence in practice one needs to consult the latest circulars and notifications issued by the RBI. ‘A convenient summary of exchange restrictions in its member countries is published by the IMF in its annual publication titled Exchange Arrangements and Exchange Restrictions. ‘The liberalisation and unification of the exchange rate in 1998 signalled a significant beginning, in the direction of freeing external transactions from cumbersome administrative controls, While exchange controls on some current account transactions and all capital account transactions are still in place there is now a distinct possibility that the former will be eliminated in the near future while the latter will be relaxed only gradually'®, The successive revisions of the guidelines governing external commercial borrowings clearly show a trend towards relaxation of restrictions in terms of size and maturity of borrowings which do not require prior approvals. Restrictions on maximum tenor of forward contracts have been done away with and the RBI at one time permitted transactions like third currency forwards and forward-forward swaps. However, during episodes of excessive volatility in the market, the RBI may and does bring back some of the restrictions at least temporarily. Thus freedom to cancel and rebook forward contract was partially withdrawn as also the freedom to do forward-forward swaps during periods of extreme volatility. These have been restored after the markets stabilised but may be withdrawn during similar episodes of market panics. ‘The limits on balances that can be held in 79 On August 18, 1994, the RBI Governor announced that India is moving to Article VIII status under the IMF articles of agreement. This means that restrictions on current account transactions will be completely &month SIUSD (right scale)The Foreign Exchange Market 9 ‘A detailed description of the structure of India’s foreign exchange market, the trading platforms and the various policy measures implemented after moving to a unified market determined exchange rate in 1993 can be found in Chapter VI titled “Foreign Exchange Market” in RBI's annual report on currency and finance of April 2007. Exchange Rate Calculations Foreign exchange contracts are for “cash” or “ready” delivery which means delivery on same day, “oalue next day” which means delivery on next business day and “spo!” which is delivery two business days later, For forward contracts, either the delivery date may be fixed in which case the tenor is computed from the spot value date or it may be an option forward in which case delivery may be during a specified week or fortnight, in any case not exceeding one calendar month, Till August 2, 1993, exchange rate quotations in the wholesale (ie. inter-bank market) used to be given as indirect quotations, ie. units of foreign currency per Rs 100. Since then, the market has shifted to a system of direct quotes given as rupees per unit (or per 100 units) of foreign currency, with the bid rate referring to the market maker buying the foreign currency and the offer rate being the market maker's rate for selling the foreign currency. We are already familiar with this way of quoting exchange rates. ‘The rates quoted by banks to their non-bank customers are called “Merchant Rates”. Banks quote a variety of exchange rates. The so-called “TT” rates (the abbreviation TT denotes “Telegraphic Transfer’) are applicable for clean inward or outward remittances, ie. the bank undertakes only currency transfers and does not have to perform any other function such as handling documents. For instance, suppose an individual purchases from CitiBank in New York a demand draft for $2000 drawn on CitiBank Bombay. The New York bank will credit the Bombay bank’s account with itself immediately. When the individual sells the draft to CitiBank Bombay, the bank will buy the dollars at its “IT Buying Rate”. Similarly, “TT Selling Rate” is applicable when the bank sells a foreign currency draft or MT. TT buying rate also applies when an exporter asks the bank to collect an export bill and the bank pays the exporter only when it receives payment from the foreign buyer as well as in cancellation of forward sale contracts. (In these cases there will be additional flat fees.) When there is some delay between the bank paying the customer and itself getting paid, e.g. when the bank discounts export bills, various margins are subtracted from the TT buying rates. Similarly, on the selling side, when the bank has to handle documents, ete. apart from effecting the payment, margins are added to the TT selling rate. The margins are subject to a ceiling specified by the FEDAI (Foreign Exchange Dealers’ Association of India) though a bank can charge less. All this is best illustrated by some examples. We will explain the principles of rate computation in the text; several worked examples can be found in the appendix to this chapter. TT Buying Rate This rate is calculated as: ‘TT Buying Rate = A Base Rate - Exchange Margin The “base rate” is the interbank rate. Thus suppose the interbank bid rate for US dollars is Rs 48.85 and the bank wants exchange margin of 0.125% the TT buying rate would be:120, International Finance (48.85)(1 - 0.00125) = 48,7889 rounded off to 48.797 ‘Thusif a draft for $10,000 is cashed by the bank where its overseas account has already been credited, it will give Rs [48.79 x 10000] = Rs 487,900 ° ‘When cashing a personal cheque or a banker's cheque payable overseas the bank will not give this rate because it has to send the cheque overseas for collection. This means a delay which is called transit period. The bank will further subtract an exchange margin from the TT buyingrate and also recover interest from the customer for the transit period. The transit periods for various countries are specified by the FEDAI and the interest rate to be charged is specified by the RBI, The purpose of the exchange margin is to recover the costs involved and provide a profit margin to the bank. Bill Buying Rate Exporters draw bills of exchange on their foreign customers. They can sell these bills to an AD for immediate payment. The AD buys the bill and collects payment from the importer. Since there is delay between the AD paying the exporter and itself getting paid, various margins have to be subtracted from the TT buying rate to compute the bill buying rate. Bills are of two kinds. Sight or Demand Bills require payment by the drawee on presentation. The delay involved in such a bill is only the transit period. Time or Usance Bills give time to the importer to settle the payment, ie. the exporter has agreed to give credit to the importer. In such cases the delay involved is transit period plus the usance or credit period. In addition to the exchange margin to cover costs and provide profit, the AD will now load the forward margin for an appropriate period. The period for which forward margin is to be loaded depends upon whether the foreign currency is at a forward discount or premium. The principle is that the AD will extract the rate which is most favourable to itself. The rate computation formula is laid out below. Bill Buying Rate Bill Buying Rate = The base rate - Forward discount for transit plus usance period rounded off to the higher month - Exchange Margin OR Bill Buying Rate = The base rate + Forward premium for transit plus usance period rounded off to the lower month ~ Exchange Margin In addition, the bank is entitled to recover from the customer, interest for the transit plus usance period!® ‘The use of this formula is illustrated by some examples worked out in the appendix to this chapter. FEDAI prescribes rales for rounding off for various currencies. See Rule 7 in Rules of FEDAI June 1991, p44. Rates are quoted up to four decimal points in interbank dealings with the last two digits in multiples, ‘of 25 while merchant rates are quoted up to two decimal points, rounded off to the nearest paisa. + This interest is charged on account of the fact that in buying the bil rom the customer, the bank is paying, the customer immediately. In a forward deal, both parties deliver at maturity. Ifa bill is submitted for collection, the bank pays only when the proceeds are realised. In such cases the TT buying rate applies. 2 FicoThe Foreign Exchange Market 121 TT Selling Rate This rate is computed as follows: TT Selling Rate = A Base Rate + Exchange Margin ‘The base rate here is the interbank selling rate. As usual, the exchange margin is subject to a ceiling specified by the FEDAL. Thus suppose acustomer wishes to purchase a draft drawn on London for £10,000. The interbank £/Rsselling rate is Rs 79.50/E The bank wants an exchange margin of 0.15%. The TT selling rate would be 79,50(1 + 0.0015) = 79.6192 rounded off to Rs 79.62 The customer will have to pay Rs [10000 x 79.62] = Rs 796200 apart from any other bank charges. Bill Selling Rate When an importer requests the bank to make a payment to a foreign supplier against a bill drawn on the importer, the bank has to handle documents related to the transaction, For this, the bank loads another margin over the TT selling rate to arrive at the Bill Selling Rate. ‘Thus Bill Selling Rate = TT Selling Rate + Exchange Margin ‘Some worked examples in the appendix illustrate the calculation of bill selling rates. Forward Buying Rate Forward Buying Rate = Spot Rate - Forward Discount for Transit plus Usance plus Forward +] Period rounded off to the Higher Month - Exchange Margin OR Forward Buying Rate = Spot Rate + Forward Premium for Transit plus Usance plus Forward Period rounded off to the Lower Month ~ Exchange Margin Forward rates are computed by subtracting the appropriate discounts or adding the premiz from the relevant spot rate. Marginsare loaded as in the case of spot rates. The rate computation formulas are laid out below. Numerical examples can be found in the appendix. Computations of cross rates are done as illustrated earlier in the section dealing with triangular arbitrage. Forward Selling Rate Forward TT Selling Rate = Interbank Spot Selling Rate (-forward discount for forward period) or (+ forward premium for forward period) + exchange margin 3.9. - FORWARD: EXCHANGE RATES IN INDIA During the last few years, a forward rupee-dollar market with banks offering two-way quotes has evolved in India. The rupee-dollar spot forward margin is not entirely determined by interest rate differentials since due to exchange controls on capital account transactions, interest arbitrage opportunities are open only to authorised dealers and that too with some restrictions. * ran122 International Finance An interbank money market has just begun to develop with active interbank deposit trading and MIBOR (Mumbai Interbank Offered Rate) as the market index. Thus the only active interbank money market is the call-money market for overnight borrowing. In the absence of a money market yield curve, arbitrage transactions across domestic and euromarket do not necessarily determine the structure of forward premia or discounts though movements in call rates do have considerable influence on overnight, Tom/Next and Spot/Next swaps. The call money market occasionally becomes extremely volatile with call money rates climbing as high as 60% pa. In such situations, banks with access to eurodollars can arbitrage across the money markets even if the forward premium on dollars goes as high as 20% p.a ‘Thus, to some extent, the call-money market drives the forward rupee-dollar margins. The other consideration is supply of and demand for forward dollars arising out of exporters and importers hedging their receivables and payables. This factor is influenced by exchange rate expectations. Hence the market has witnessed a substantial degree of volatility in forward premia on the US dollar. Exhibit 3.5 depicts movements in forward premia. Exhibit 3.5 Movements in Forward Premia — tenth —= 3 month month This absence of a tight relationship between interest differentials and forward premia also opens up arbitrage opportunities for exporting firms related to their credit requirements. A firm can avail of pre-shipment credit in foreign currency to finance its working, capital requirements instead of availing domestic rupee finance. Consider a firm which can avail of domestic credit at 13% while US dollar financing is available at LIBOR plus 3% from a domestic bank. If LIBOR is say 5%, then as long as the annualised forward premium on US dollar is less than 5%, the firm is better off taking its pre-shipment credit in US dollars. Ifthe capital account is opened up before complete deregulation of interest rates, similar situations may arise depending upon a firm's access to various different sources of borrowing and avenues for investing surplus cash, Forward contracts in the Indian market are usually option forwards though banks do offer fixed date forwards if the customer so desires. In the interbank market ryThe Foreign Exchange Market Bs forward quotes are given as swap margins from the spot to the end of successive months Exhibit 3.6 shows an extract from the Indian foreign exchange rates screen provided on line by Bridge Information Systems. Exhibit 3.6 Indian Foreign Exchange Rates - Forwards Tue, Dec 05, 15:35:16 2000 Contributor Meckiai Bank of India Annualised Equivalents Time (Local) 4:10 15:20 Bid Ask CashiTom 1 1 4at 14.72 Cashispot aby obs 1.48 11.64 Tom/Spot 0.48 /0.22 020/025 1.56 11.95 Spov28 Dec 00 6.25/6.75 6.00/7.00 2.43 1 248 Spot Jan 01 21.501 22.50 20.50 / 22.50 291 13.19 Spot/28 Feb 01 36.50 137.50 35.50/37.50 3.34 13.53 ‘Spo¥31 Mar 01 52.75 153.75 52.50 / 54.50 3.63 1 3.76 Spot 30 Apr Ot 70.50171.50 70.00 172.00 3.79 1.3.90 ‘Spou31 May 01 87.50 1 89.00 87.00 / 89.00 3.93 1 3.97 ‘Spot/30 Jun 01 4104.00 /105.50 403.00 / 105.00 3.94 1 4.02 ‘Spot/30 Nov 01 192.50 / 194.50 192.00 / 194.00 449 1423 ‘Source; Bridge Information Systems Let us see how to interpret these quotes. Take the Spot/28 Feb 01 swap quote given by Mecklai. The spot date is December 7, 2000, The outrights for February 28, 2001 are obtained by adding Rs 0.3650 to the bid side of the spot quote and Rs 0.3750 to the offer side of the spot quote. The spot rate on the same day around the same time was 46.76/ 46.77. Thus the outrights for February 28, 2001 would have been 47.1250/47.1450, An option forward with maturity on February 28, 2001 but the option of delivery over the month of February would have the same quotes. Now let us find the outright bid for a fixed date forward maturing on May 12, 2001 The premium to the end of April was 70.50 paise and to the end of May was 87.50 paise. The difference of 17 paise is spread evenly over the 31 days between April 30 and May 31 to get a premium of 0.5484 paisa per day. For 12 days this would give a premium of 6.5806 paise. The total premium to May 12 would thus be (70.50 + 6.5806) or 77.0806 paise. Taking a spot bid of Rs 46.76, the outright for May 12 would have been 47.5308. All forward transactions are for the purpose of hedging an underlying exposure such as. trade related payables and receivables or approved capital account transactions such as debt service. Many forward transactions in the Indian market between banks and their non-bank customers tend to be of the option forward type. Hence swap margins are commonly quoted from spot to end of the current and future calendar months. Banks do however do fixed-date forwards if the customer so desires, Most of the forward transactions in the Indian market are os run124 International Finance for amaximum maturity of six months but rolling over of positions is permitted”, Till January 1997, authorised dealers could offer their customers contracts for maturities longer than six months with the prior approval of the Reserve Bank of India on a case-by-case basis. Since then the requirement to obiain RBI approval has been removed. However, in the absence of an active money market in India and hence the interest parity linkage, itis very difficult for dealers to assess the correct forward rate which they should offer their customers. Forward contracts can be cancelled extended or early delivery can be arranged by paying a small cancellation fee and any settlement payments”, The latter depend upon how the rates have moved after the initial contract was entered into. Numerical examples in the appendix illustrate these calculations. For entering into forward contracts a small flat fee is charged to cover administrative expenses and stamp duty. Earlier, an exposure ina particular currency could be hedged only witha forward transaction in that currency against the rupee. Now “third currency forwards” are permitted. This means that if an Indian corporate has an exposure ina foreign currency A, itcan do a forward between currency A and another foreign currency B and leave the exposure in B open. Let us consider an example. °F Suppose an Indian firm has a 6-month payable of JPY 20 million. The market rates are as. follows: Mumbai: USD/INR spot :40.50/52 6-months : 40.80/85 Singapore: USD/JPY spot : 100.25/101.10 6-months : 101.50/102.00 From this the JPY/INR 6-month forward cross rate is: (40.80/102.00) (40.85 /101.50) = 0.4000/0.4025 = 40.00/40.25 (per 100 JPY) If the firm buys JPY forward against INR it will have to pay Rs [20,000,000/100](40.25) = Rs 8,050,000,00 ‘The firm feels that the US dollar is overvalued in the forward market. It buys JPY 20 million forward against USD and leaves the USD position uncovered. It has to deliver ‘USD [20,000,000/101.50] = USD 197,044.34 19 The 6-month limit arises from the fact that foreign currency receivables and payables arising from exports and imports have to be settled within six months and forward cover is available only for exposures arising ‘out of genuine trade transactions, Rates for matutities up to an year are available with some difficulty. Earlier, rollovers could be done at historical rates as explained above. This facility has been withdrawn. ‘Now rollovers are done at market rates. 2 Many companies are teported to have made tidy sums by cancelling their forward purchase contracts ‘during the period prior to the 1993 budget when the rupee depreciated and forward discounts on the rupee rose significantly. Firms which did not share this gloomy view of rupee cancelled their forward contracts ‘booked earlier, leaving short open positions, In essence they speculated on the exchange rate. % Note that it makes no sense to hedge the dollar position at the current rates. It would be equivalent to buying yen against rupees forward. FansThe Foreign Exchange Market 125 Six months later, its view turns out to be correct. The spot USD/INR rate is 40.60/65. It buys the required US dollars in the spot market to deliver against its forward contract. It hhas to pay: Rs [197044.34 x 40,65] = Rs 8,009 852.22 Thus the firm saves Rs 40147,78, Note however, that this is a speculative strategy. Another new product in the Indian market is “forward-forward contracts”. tis very similar to the forward-forward swaps discussed above. We will look at its application ina later chapter. In recent years there has been considerable deepening and liberalisation of the forward markets in India against the major currencies like USD, GBP, EUR and JPY. Markets beyond 6- months maturities are virtually non-existent. Since late 1995, the forward margins have been quite volatile. At one time, to book every forward contract the company had to produce evidence of exposure —export receivable or import payable or interest payable on a foreign currency loan etc. as the case may be. Now the regulations permit booking of forward contracts based on a company’s export or import business during the past three years. The eligible limit for amount of forward purchases or sales during an year equals the average of previous three years import/ export turnover. Documentary evidence of exposure has to be produced at the time of expiry of the contract. Contracts in excess of 75% of the eligible limits cannot be cancelled. Details of these and other regulatory provisions can be found in a circular issued by RBI to authorised dealers dated December 13, 2006 titled “Booking of Forward Contracts Based on Past Performance”. Subsequently further modifications have been announced which can be found on RBI's website. The appendix to this chapter contains some examples of calculation of forward rates applicable to merchant transactions. It also contains the terms and conditions applicable to booking a forward contract with an authorised dealer in India. 7 rere- International Finance APPENDIX A.1.1 2 THE BALANCE OF PAYMENTS A precise definition of the Balance of Payments (BOP) of a country can be stated as follows: ‘The balance of payments is an accounting record of all economic transactions between the residents of a country and residents of foreign countries. ‘The phrase “residents of foreign countries” may often be replaced by “non-residents”, “foreigners” or “Rest of the World (ROW)”. There are two simple rules of BOP accounting: (a) A transaction that leads to an actual or potential payment from residents of a country to ROW is to be recorded as debit; in that country’s BOP; a transaction that leads to a payment from ROW to residents is a credit entry. (b) A transaction that increases the availability or reduces demand for foreign exchange is a credit entry; a transaction that uses up foreign exchange is a debit entry. Consider an export from India to say Germany. This leads to a payment from Germany toa resident exporter and hence according to rule (a) it should be recorded as a credit. The German importer pays the Indian exporter with Euro draft drawn on a German bank say Commerzbank. ‘The exporter sells this draft to his Indian bank say SBI. SBI sends this draft to its correspondent bank in Frankfurt say Deutschebank. Deutschebank collects on it and credits the amount to SBY’s account with itself. This leads to an increase in SBI's foreign assets—a use of foreign exchangeand hence according to rule (b)a debit entry which offsets the credit entry. As we will see below, the credit entry will be made in the current account while the offsetting, debit entry in the capital account. There are some technical matters pertaining to the definition of “resident”, the timing of recording the various entries (for instance should the credit entry for an export be recorded when the shipmentis made or when payment is received) as well as basis of valuation (eg. should one use F.O.B. or CLF. values). These need not concer us here. + Components of the Balance of Payments ‘The BOP ig a collection of accounts conventionally grouped into three main categories with subdivisions in each. The three main categories are: (a) The Current Account: Under this are included imports and exports of goods and services and unilateral transfers of cash, goods and services. (b) The Capital Account: Under this are grouped transactions leading to changes in foreign financial assets and liabilities of the country. (c) The Reserve Account: In principle, this is no different from the capital account in as muuch as it also relates to financial assets and liabilities. However, in this category only “reserve assets” are included. These are the assets which the monetary authority of the oeGlobal Financial Environment 35, country uses to settle the deficits and surpluses that arise in the other two categories taken together®. In what follows we will examine in some detail each of the above main categories and their subdivisions. Our aim is to understand the overall structure of the BOP account and the nature of relationships between the different sub-groups. We will not be concerned with details of the valuation methodology, data sources and the various statistical compromises that have to be made to overcome data inadequacy. We draw extensively on the Reserve Bank of India ‘monograph Balance of Payments Compilation Manual. [RBI (1987)]. Readers interested in exploring methodological details can consult this source. The Current Account The structure of the current account in India’s BOP statement is shown, in Exhibit A.1.1. Exhibit A.1.1.. Structure of Current Account in India’s BOP Statement ‘A. CURRENT ACCOUNT Credits Debits Net |. Merchandise Ul, Invisibles (abc) (@) Services| () Travel (i) Transporation (ii) Insurance {(v) Government not classified elsewhere (¥) Miscellaneous (0) ‘Transfers (vi) Offical (vi) Private (©) Investment inoome TOTAL CURRENT ACCOUNT (I+ It) ‘We will briefly discuss each of the above heads and subheads. Merchandise In principle merchandise trade should cover all transactions relating to movable ‘g00ds, with a few exceptions, where the ownership of goods changes from residents to non- residents (exports) and from non-residents to residents (imports). The valuation should be on £o.b. basis so that international freight and insurance are treated as distinct services and not merged with the value of the goods themselves. ® Reserve assets are financial assets which are acceptable as means 6f payment in intemational transactions and are held by and exchanged between the monetary authorities ofthe trading countries. They consist of monetary gold, assets denominated in foreign currencies, special drawing rights and reserve positions in the IMF Deficits and surpluses on the other two categories lead to depletion and accumulation of reserves respectively. >» Among the exceptions are goods such as ships, airline stores, etc. purchased by non-resident transport ‘operators in the given country and similar goods purchased overseas by that country’s operators, purchases of foreign travellers, purchases by diplomatic missions, et. rare36 international Finance Exports, valued on f.o.b, basis, are the credit entries. Data for these items are obtained from the various forms exporters have to fill and submit to designated authorities. Imports valued at cif. are the debit entries. Three categories of imports are distinguished according to the mode of payment and financing, [see RBI(1987) for details.] Valuation at cif, though inappropriate, is a forced choice due to data inadequacies. The difference between the total of credits and debits appears in the “Net” column. This is the Balance on Merchandise Trade Account, a deficit if negative and a surplus if positive. Invisibles Conventionally, trade in physical goods is distinguished from trade in services. The invisibles account includes services such as transportation and insurance, income payments and receipts for factor services and unilateral transfers. Credits under invisibles consist of services rendered by residents to non-residents, income earned by residents from their ownership of foreign financial assets (interest, dividends), income earned from the use, by non-residents, of non-financial assets such as patents and copyrights ‘owned by residents and the offset entries to the cash and in-kind gifts received by residents from non-residents. Debits consist of same items with the roles of residents and non-residents reversed. A few examples will be useful: 1. Receipts in foreign exchange, reported by authorised dealers in foreign exchange, remitted to them by organisers of foreign tourist parties located abroad for meeting hotel and other local expenses of the tourists. This will be a credit under “travel”. 2. Freight charges paid to non-resident steamship or airline companies directly when imports are invoiced on f.o.b basis by the foreign exporter will appear as debits under “transportation”. 3. Premiums on all kinds of insurance and re-insurance provided by Indian insurance ‘companies to non-resident clients is a credit entry under “insurance” 4, Profits remitted by the foreign branch of an Indian company to the parent represent a receipt of “investmentincome”, Itwill be recorded as a credit under “investment income”, Interest paid by a resident entity on a foreign borrowing will appear as a debit. 5. Funds received from a foreign government for the maintenance of their embassy, consulates, etc. in India will constitute a credit entry under “government not included elsewhere”. 6. Payment to a foreign technical consultant for professional services rendered will appear as a debit under “miscellaneous”. 7. Revenue contributions by the Goverament of India to international institutions such as the UNora gift of commodities by the Government of India to nor-residents will constitute a debit entry under “official transfers”. Cash remittances for family maintenance from Indian nationals residing abroad will be a credit entry under “private transfers”. The net balance between the credit end debit entries under the heads merchandise, non- monetary gold movements and invisibles taken together is the Current Account Balance. The net balance is taken as deficit ifnegative (debits exceed credits), and a surplus if positive (credits exceed debits). The Capital Account The capital account in India’s BOP is laid out m Exhibit A.1.2. ‘The capital account consists of three major subgroups. The first relates to foreign equity investments in India either in the form of direct investments—e.g. Ford Motor Co. starting a 100 runeGlobal Financial Environment 37 car plant in India—or portfolio investments such as purchase of Indian companies’ stock by foreign institutional investors. The next group is loans. Under this are included concessional loans received by the government or public sector bodies, long and medium-term borrowings from the commercial capital market in the form of loans, bond issues, ete. and short-term credits such as trade related credits. Disbursements received by Indian resident entities are credit items while repayments and loans made by Indians are debits. The third group separates the ‘changes in foreign assets and liabilities of the banking sector. An increase (decrease) in assets are debits (credits) while increase (decrease) in liabilities are credits (debits). Non-resident deposits with Indian banks are shown separately. ‘The total capital account consists of these three major items and two other minor items shown under “rupee debt service” and “other capital”. The Other Accounts The remaining accounts in India’s BOP relate to transactions in Reserve Assets. The IMF account contains, as mentioned above, purchases (credits) and repurchases (debits) from the IMF, SDRs— Special Drawing Rights—are a reserve asset created by the IMF and allocated from time to time to member countries. Within certain limitations it can be used to settle international payments between monetary authorities of member countries. An allocation is a credit while retirement is a debit. The Reserves and Monetary Gold account records increases (debits) and decreases (credits) in reserve assets. Reserve assets consist of BGIIPAM.2 Structure of the Capital Account B. CAPITAL ACCOUNT (1 to 5) 1. Foreign investment (atb) (@) In India () Direct (i) Portfolio (b) Abroad . Loans (arb+e) (a) Exteral Assistance (i) By India (i) To India (©) Commercial Borrowings (MT and LT) () By India (i) To India (©) Short-Term To India Banking Capital (a+b) (@) Commercial Banks () Assets (i) Labities (i) Non-resident Deposits (©) Others . Rupee debt Service 5. Other Capital rr38 Intemational Finance RBI's holdings of gold and foreign exchange (in the form of balances with foreign central banks and investments in foreign government securities) and Government's holdings of SDRs. This completes our examination of the structure of India's BOP. In the next section we will Jearn the meaning of the terms “deficit” and “surplus” in the balance of payments and the relationship between the three major categories of accounts. A.1.2 3 MEANING OF “DEFICIT” AND “SURPLUS” IN THE BALANCE OF PAYMENTS If the BOP is a double-entry accounting record, then apart from errors and omissions, it must always balance. Obviously, the terms “deficit” or “surplus” cannot then refer to the entire BOP but must indicate imbalance on a subset of accounts included in the BOP. The “imbalance” must be interpreted in some sense as an economic disequilibrium, Since the notion of disequilibrium is usually associated with a situation that calls for policy intervention of some sort, it is important to decide what is the optimal way of grouping the various accounts within the BOP so that an imbalance in one set of accounts will give the appropriate signals to policy makers. In the language of an accountant we divide the entire BOP into a set of accounts “above the line” and another set “below the line”. If the net balance (credits-debits) is positive above the line we will say that there is a “balance of payments surplus”; if itis negative we will say there is a “balance of payments deficit”. The net balance below the line should be equal in magnitude and opposite in sign to the net balance above the line. The items below the line can be said to be of a “compensatory” nature—they “finance” or “celtle" the imbalance above the line. The critical question is how to make this division so that BOP statistics, in particular the deficitand surplus figures, will be economically meaningful. Suggestions made by economists and incorporated into the IMF guidelines emphasise the purpose or motive behind a transaction as the criterion to decide whether the transaction should go above or below the line. The principal distinction is between autonomous transactions and accommodating or compensatory transactions. An autonomous transaction is one undertaken for its own sake, in response to the given configuration of prices, exchange rates, interest rates etc., usually in order to realise a profit or reduce costs. It does not take into account the situation elsewhere in the BOP. An accommodating transaction on the other hand is undertaken with the motive of settling the imbalance arising out of other transactions, e-. financing the deficits arising out of autonomous transactions. All autonomous transactions should then be grouped together “above the line” and all accommodating transactions should go “below the line”. The terms balance of payments deficit and balance of payment surplus will then be understood to mean deficit or surplus on all autonomous transactions taken together. Such a distinction, while easy to propose in theory (and economically sensible) is difficult to implement in practice in some cases. For some transactions there is no difficulty in deciding the underlying motive, e.g. exports and imports of goods and services, private sector capital flows, migrant workers’ remittances, unilateral gifts are all clearly autonomous transactions. Monetary authority's sales or purchases of foreign exchange in order to engineer certain movements in exchange rate is clearly an accommodating transaction. But consider the case of the government borrowing from the World Bank. It may use the proceeds to finance deficits on other transactions or to finance a public sector project or both. In the first case, it is an 102Global Financial Environment 39 accommodating transaction; in the second case it is an autonomous transaction while in the third case it is a mixture of both ‘The IMF at one stage suggested the concept of compensatory official financing. This was to be interpreted as “financing undertaken by the monetary authority to provide (foreign) exchange to cover a surplus or deficit in the rest of the BOP”. This was to include use of reserve assets as well as transactions undertaken by authorities for the specific purpose of making up a surplus or a deficit in the rest of the balance of payments. However, this concept did not really solve the problem of ambiguity mentioned above. Later, the IMF introduced the notion of overall balance in which all transactions other than those involving reserve assets were to be “above the line”. Thisis a measure of residual imbalance which is settled by drawing down or adding to reserve assets. In practice, depending upon the context and purpose for which it is used, several concepts of “balance” have evolved. We will take a look at some of them. L. Trade Balance: This is the balance on the merchandise trade account, ie. item I in the current account, 2, Balance on Goods and Services: This is the balance between exports and imports of goods and services. In terms of our presentation, itis the net balance on item I and sub- items 1-6 of item Il taken together. 3. Current Account Balance: This is the net balance on the entire current account, items I+ IL+IIL, When this isnegative we havea current account deficit, when positive, a current account surplus and when zero a balanced current account. 4, Balance on Current Account and Long-Term Capital: This is sometimes called basic balance. This is supposed to indicate long-term trends in the BOP, the idea being that while short-term capital flows are highly volatile, long-term capital flows are of a more permanent nature and indicative of the underlying strengths or weaknesses of the economy™. Indiscussing the BOP we have left out an item which inevitably appears in all BOP statements in practice, viz. “Errors and Omissions”. While changes in reserve assets are accurately measured, recording of other items is subject to errors arising out of data inadequacy, discrepancies of valuation and timing, erroneous reporting, etc. These have to be reconciled by introducing a fictitious head of account called errors and omissions. A133 CURRENCY CONVERTIBILITY Currencies like the US dollar, Japanese yen, Deutsche mark are said to be “fully convertible” while those like the Burmese kyat or Cuban peso are said to be non-convertible. In India right now debate is on about the advisability of making the rupee convertible on “capital account”. Convertibility of a currency is a matter of degree. IMF defines a currency to be “convertible” if itis freely convertible into a foreign currency and vice-versa forall transactions included in the © Recall however that the distinction between long- and short-term capital is made on the basis ofthe orginal raturity of the asset. A five-year original maturity bond with three months left to maturity is no more permanent than a three month deposit. Also, while investment in equity shares is considered to be long term it is one of the most easily marketable asset. 103 ae. 40 International Finance current account of the balance of payments. Note that this does not mean that there are no restrictions on foreign trade—import and export duties, quotas, prohibitions, etc. These are matters of trade restriction and not currency convertibility. What current account convertibility means that provided a current account transaction does not violate any provisions of trade control (or any other relevant legislation), the home currency can be freely converted into any foreign currency and vice-versa in settlement of such a transaction. In this sense, the Indian rupee became (almost fully) current account convertible in August 1994, There are still some restrictions on items such as travel. For transactions falling under the capital account — foreign currency borrowing and investment, joint ventures, holding foreign bank accounts, etc. ifthe amounts involved are beyond certain limits, prior approvals from the Government of India and the Reserve Bank of India are needed. These limits are changed from lime to time. The Tarapore Committee has recommended that the rupee be made convertible on capital account in three phases from 1997 to 2000, However following the Asian currency crisis, political uncertainty at home, the Russian collapse and the resultant turmoil in global financial markets, doubts are being Voiced in many circles about the advisability of free capital flows and full convertibility partculaiy for a developing country. 194 Bretton Woods, New Hampshire conference established an adjustable peg system of quasi- fixed exchange rates with the US dollar as the key currency. IMF and World Bank created IMF to supervise the International Monetary System. 1958 Birth of the European Economic Community (EEC). 1963 The US government imposed an “Interest Equalization Tax” on foreign issuers funding in US capital markets. 1963 The US government imposed voluntary foreign credit restraints on the US banks and ‘companies. 1968 Mandatory controls on foreign investment by US companies imposed by the US government. 1970 Special Drawing Rights created. 1971 On August 15, the USS floated; the convertibility of the USS into gold abandoned; ‘On December 17, Smithsonian Agreement reached; the USD devalued from $35 per ounce of gold to $38. 1972.A snake (2.25%) within a tunnel (4.5%) established among major European currencies, 1973 The USD devalued from $38 to $42.22 in March. 1973 The oil price crisis. Oil prices quadruple. 1976 “Jamaica Agreement”. IMF “recognises” the existing floating system. 1978 The European Monetary System (EMS) officially replaced the snake within a tunnel. European currencies jointly float against the US dollar. 1980 Latin American debt crisis. 1985 Group of Five countries reached “Plaza Agreement” to drive down the US dollar. 104 rosChapter 2 DYNAMICS OF EXCHANGE RATE MECHANISM. INDEX Exchange Rate Mechanism- an Introduetion 48) Different method of quoting exchange rates t Quotation Indirect quotation + Two way quotation b) Different transactions and relevant exchange rates Buying rate Selling rate Calculation of merchant rates, Cross rates / Chain rule Card rates Spread ©) Spot Rates ~ Forward Rates + Premium / Discount on direct quotations * Quoting forward rates snes M82 105Exchange Rate Mechanism: An Introduction Intemational transactions, if we export goods to other countries, our exporter in India ‘would like to be paid in Indian Rupees whereas the forcign buyer would like to pay in his home currency. If the buyer is in United States, he will pay only in US Dollars. ‘Thus it becomes necessary to convert this US Dollars into Indian Rupees. The rate at which USD is converted into Indian Rupees is known as "Exchange Rate". In short exchange rate is the ratio used to convert one currency into another. Exchange rates are quoted under two methods: 1. Direct method 2. Indirect method. DIRECT QUOTATIONS. While quoting the exchange rate for a currency if the unit of foreign currency is kept constant and its value is expressed in terms of variable home currency the method of quoting exchange rate is known as Ditect Quotation. In this ease, the unit of home currency will be varying for every unit of foreign currency. eg, USD 1=Rs. $4.2375 GBP 1=Rs. 3.8968 fective from August, 6, 1993 we have changed our sysiem of quoting exchange rates to ct Quotations. By adopting this system we have fallen in line with the Intemational practice. It has become more transparent for the dealing public and it will be easier for them to follow up the movement of exchange rates INDIRECT QUOTATIONS When the unit of home currency is kept constant and the unit of home currency is expressed in terms of variable units’ foreign currency, then this method of quoting exchange rate is called Indirect Quotation, Prior to August 1993 we were following this system for quoting exchenge rates. + Rs.100/-=USD 1.8437 TWO WAY QUOTES: In other commercial transactions whenever we enquire the price of a commodity the seller will immediately quote his selling price. But in Foreign exchange market exchange rates are always quoted for buying and selling ic., one rate for buying and the other rate for selling. For example, if Bank X calls forthe rates from Bank Y for USD/INR Bank Y will quote: USD 1 =Rs.54.24/34 FM-RSIt means that Bank Y is prepared to buy USD at Rs.54.24 and sell at $4.34. This method of quoting both buying and selling rates is known as "TWO WAY QUOTATION’. For all practical purposes if we treat Foreign Exchange as a commodity, the logic and application of this ‘Two-way quotation’ can be understood easily i.c., a trader will always be willing to buy a commodity at a lesser price and sel ata higher price. ‘The principle or maxim involved in this method of quotation is: "BUY LOW - SELL HIGH" (UNDER DIRECT QUOTATION) b) DIFFERENT TRANSACTIONS AND RELEVANT EXCHANGE RATES: In the above examples, case (a) is an outward remittance, which does not involve any additional manpower. Bank will be recovering the rupee equivalent from the customer ‘and remit the foreign exchange to their correspondent Bank as per their drawing arrangements with instructions to pay to the lending financial institution on behalf of their customer. If itis a remittance relating to an import bill, case (b), as a banker, bank ‘will be verifying the documents, entering them in their register, presenting the bill to the importer for payment and also check whether all the conditions stipulated by the cotrespondent bank ate complied with. For this nature of involvement of manpower, Bank is eligible for some additional compensation. ‘This compensation will be loaded or adjusted while quoting the exchange rate for this import transaction. In other words, the exchange rate for import transaction will be costlier to the customer when compared to the exchange rate for clean outward remittances. The different rates quoted for these two ‘ransactions are TT selling and bill selling. Likewise Bank inward remittances. quote different buying rates for export bills and for other clean Following are the different rates, which are quoted to the customer depending upon the nature of transaction: BUYING RATE! Al TI Buying Rate: (NATURE OF TRANSACTIONS) 1, Clean inward remittance (TT, PO, MT, and DD) for which cover has already been provided in AD's Nostro Account abroad. 2. Conversion of proceeds of instruments sent on collection basis. [When proceeds are credited to Nostro Account] Cancellation of outward TT, MT, PO, DD etc. Cancellation of forward sale contract. ‘Undrawn portion of an Export Bill realised. 2. Bill Buying Rate: (NATURE OF TRANSACTIONS) paee 1. Purchase/ negotiation/ discounting of export bills and other instruments. EM-8i 107SELLING RATE: B.l. TT Selling Rate, (NATURE OF TRANSACTIONS) ‘Outward remittance in foreign curreney (TT, MT, PO, DD) 2. Cancellation of purchase transactions, Bill purchased earlier is returned unpai Bill purchased earlier is transferred to collection account. Inward remittance received earlier (converted into rupees) is refunded to the remitting bank. 3. Cancellation of Forward purchase contract. 4. Remittances relating to payment of import bills, which are directly received by the importer. 5. Crystallisation of overdue export bills. NOTE:If the remittance is a clean remittance i.e, no documents are to be handled by the banks TT Selling rate will be applied. B.2. Bill Selling Rate, 1, Transaction involving remittance of proceeds of import bill (except bills received directly by the importer) NOTE: Even if the proceeds of the import bills are to be remitted in foreign Currency by way of DD, MT, TT, and PO rate to be applied will be Bill Selling rate. 2. Crystallisation of overdue import bills. ‘Apart from the above, separate rates will be quoted for selling and buying of Travellers ‘Cheques and Foreign curreney notes. CALCULATION OF MERCHANT RATES: FEDAI has provided detailed guidelines for calculation of exchange rates for merchant transactions. Following factors are to be taken into account by banks before quoting rates to customers: STEP 1, Arrive at the cover rate ie. the rate at which ADs will be covering the transaction in the market immediately the customer delivers the instrument. It may also be treated as the rate at which the AD can dispose off / acquire the Foreign Exchange itvftom the market. STEP 2. Load the prescribed profit margin: EXCHANGE MARGIN: FEDAL has left the discretion of loading profit margin to the individual banks, FMS 108First leg of the transaction is, Authorised Dealer procures USD against Indian Rupees from inter-bank market: USD $1 =Rs.54.34 i. to procure USS 1, AD will pay Rs.54.34 in the Interbank, With this USD, AD will go to London market and procure EUR paying USD 1.3314 for one EUR By applying Chain Rule: 1 EUR = USD 1.3314 TUSD = INR 54.34 ‘Then 1 EUR will be equivalent to 1.3314*54.34 = INR72.3483 Rounding off to 4 decimals = Rs.72.3475, This method of arriving at the value of other currencies through US Dollar or any other third currency is known as Cross Rate or Chain Rute CARD RATES: Dealing room of all banks as soon as open for that day's business, works out the exchange rate for all the major currencies and for all types of transactions. This rate will be communicated to all branches of the bank. This rate will be the indicative rates and this rate'will be applicable only for transaction up to the prescribed level ie., smaller value transactions. Spot Rates - Forward Rates, ‘We have leamt that exchange rate is the price at which one currency can be bought or sold for another curreney. ‘The date on which currencies are exchanged can be any date from the date starting from the date of transaction to any future dates. ‘Transactions may be either Spot or Forward depending upon the delivery of the Foreign Exchange. Under Spot we have CASH-SPOT, TOM-SPOT. If the exchange of currencies takes place on the same day of transaction it is known as CASH DEAL. If the exchange of ccurtencies takes place on the next working day, ie. tomorrow, it is known as TOM- DEAL. If the exchange of currencies takes place on the second working day after the date of transaction it is know as SPOT DEAL. Normally exchange rates are quoted on spot basis ie. the settlement will take place on the second working day after the date of. transaction. Wherever foreign exchange will be delivered after SPOT date it is known as Forward transactions. M87 109It is now purely at the discretion of the individual Bankers to load the appropriate exchange margin and improve the exchange rate depending upon the volume and nature of the transaction. STEP 3. Rounding off the transaction to the nearest 4 decimals ie. .0025/S0/75/00, EXAMPLE: Exporter has submitted a bill for USD 100,000. Inter bank exchange rate 54.24/34 Profit margin 1.5 paise STEP 1. Select the appropriate base rate at which the bank can dispose off the USD against Indian Rupee in the market. In this case Bank may be able to dispose off USD 100000 at Rs 54.24 in the Inter bank market at tite market-buying rate, STEP 2, Load the prescribed profit margin: Base rate.... Rs.54.24 Deduct the profit margin: Rs.54.24 - 0.0150 = Rs.54.2250 Since Bank will be paying Indian Rupees to exporter customer, Bank will be deducting their profit margin from the rupee proceeds. STEP 3, Round off to the nearest 4 decimals, In the above transaction Bank will be quoting the rate as 54.2250 to the customer. CROSS RATES / CHAIN RULE: If a Corporate wants to purchase Euro (EUR) since this currency is not normally quoted in India, AD will procure US Dollars from Inter bank market against Rupees and will contact any of the overseas market to get Euro by disposing the US Dollars. E.g,, A customer wants to retire an import bill for EUR 50,000 and the Inter Bank rate for USD/INR is at 54.24/34 and the overseas market rate for EUR/USD is 1.3304/14. In order to arrive at the EURVINR exchange rate Bank will be applying following Chain Rule method. It should be noted that the market quote for EUR/USD is expressed under Indirect quotation i.e., one unit of Euro will be equivalent to how much USD. FM-86 110Going back to the above Import transaction, if the Importer gets the information that his shipment will be reaching India only after 3 months it is possible that due to exchange fluctuations he may have to pay more in Rupee terms. If he feels that the exchange rate on the thicd month, at the time of retirement of the import bill, will not be favorable to him, he may like to fix an assured rate for his future transaction. This type of fixing the exchange rate for a future transaction, at the desired time earlier to the date of actual transaction is known as Forward contract. PREMIUM/DISCOUNT ON DIRECT QUOTATIONS: If we are familiar with commodity or share market it would be known that spot rate and forward rates are different and they need not be the same. This is so because the anticipated demand and supply and the cost situations at the forward date may not with that of the existing at present. The commodity/share could bbe quoted at a higher (premium) or lower (discount) rate for future deliveries. ‘We shall illustrate this with an example: Spot interbank rate of USD 1 = Rs54.24 3 months forward USD 1 =Rs 54.94 If one has to buy dollar three months forward against Rupees, he has to pay 70 paise ‘more for the same dollar, i.¢., 3 months dollar will be costlier by 70 paise compared to spot rate. Therefore US Dollar is said to be at premium in forwards vis-a-vis rupee. In direct quotations premium is always added to both the buying and selling spot rates. In another situation: Spot interbank rate of USD 1 = JPY 83.48 3 months forward USD 1 = JPY 81.48 From the above illustration it will be seen that the USD/JPY for 3 months forward is available at a cheaper rate as compared to spot. In other words USD is cheaper by 2 JPY forward compared to spot. ie, USD is at discount in forwards vis-a-vis JPY direct quotations. Discount factor is always deducted from the buying and selling spot rate. From the above itis now clear that if we compare spot and forward rates we are able to arrive at the following three possibilities: ‘a, Ifthe spot rate and the forward rate are the same they are at par. b. In direct quotations if forward rate is more than the spot rate the base currency is said to be at premium. ‘c. Indireet quotations if forward rate is less than the spot rate the base currency is said to be at discount.QUOTING FORWARD RATES: Forward differentials are always quoted in two figures like, 15/16 and 15/14, Tt will be cither at ascending ot descending order. If he first figure is less than the second figure {in ascending order} then the base currency is said to be at premium. In direct quotations premium is always added to both the buying and selling rates. If it is ‘buying transaction for the bank, the quoting bank will add lesser of the two premium. figures so as to give minimum rupees. Likewise if itis a selling transaction, the quoting bank, will add higher of the two premium figures s0 as to take the maximum amount in rupees for selling a foreign eurrency. EXAMPLE Interbank market rates: Spat USDI = Rs.$4.2400/3400 T month forward 15/16 a) We have an export bill buying transaction. Since the forward differentials are in ascending order the base currency USD is at ‘premium. Hence it should be added with the spot rate to arrive at the forward rate, Out of the two premium figures (15/16) since Bank will be giving Indian rupees, they will give minimum amount in rupees. Stop 1 Spot buying rate USD 1 = Rs.54.2400 Stop 2. To arrive at the forward ra Since the base currency is at premium and Bank has to give rupees, add the minimum premium, ic., add 15 paise to the spot rate, Spot buying rate USD 1 = Rs54.2400 Add premium Rs,00.1500 Rs.54.3900 Hence the forward rate for this export transaction will be Rs.54.3900. b) In an import transaction, while recovering rupees from the importer ‘customer, for one-month forward rate, Bank will add the maximum premium i.e. 16 paise and the forward rate for Bank’s selling transaction would be: Spot selling rate USD 1 = Rs.54.3400 ‘Add premium 00.1600 Forward rate for selling = Rs.54,5000 Ifthe forward differentials are on the descending order ic.,25/24, the base currency is said to be at discount, FM89 12In direct quotations, if the base currency is at discount, discount factor is always deducted {rom the spot rate, When two discount figures are quoted, if it is a buying transaction (export bills) in which bank will be giving rupees, they will be deducting the igher of the two figures and give minimum rupees. Interbank market Spot USD 1 = Rs.54.2400/3400 1 month forward 25/24 (paise) To arrive at the 1 month forward rates: Buying Selling (export Bill) {import bill) Inter bank Spot _$4.2400 54,3400 Deduct the discount 0.2500 0.2400 1 month forward rate 53.9900 54,1000 From the above example, in direct quotations, in selling transactions, lesser amount of

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