Local

Local Foreign
Foreign Exchange
Exchange Market
Market

By
By
Muhammad
Muhammad ARIF
ARIF
Senior
Senior Joint
Joint Director
Director
FSCD
FSCD
 A Comment

“There is no sphere of human influence in which

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

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 Structure of the Presentation

Basic Concepts, Terminologies, Instruments &

Mechanism.
 Exchange Rate Regimes

 Historical perspective

 Foreign Exchange Trading & rate quotations

 Role of SBP in the FX Market.

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 BASIC CONCEPTS/TERMINOLOGIES
Foreign Currency v/s Foreign Exchange

As per Foreign Exchange Act, (Section 2), 1947.

(c)"Foreign Currency" means any currency other than
Pakistan currency;
(d) "Foreign Exchange" means includes any instrument
drawn, accepted, made or issued under clause (8) of section
17 of the State Bank of Pakistan Act, 1956, all deposits,
credits and balance payable in any foreign currency, and any
drafts, traveler’s cheques, letters of credit and bills of
exchange, expressed or drawn in Pakistan currency but
payable in any foreign currency;
 Financial Markets
 Financial market is a place where
Resources/funds are transferred from those
having surplus/excess to those having a
deficit/shortage.

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 Foreign Exchange Markets
 The market where the commodity traded is
Currencies.
 Price of each currency is determined in term of
other currencies.

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 What is an Exchange Rate ?
Exchange Rate is the price of one country's currency
expressed in another country's currency. In other
words, the rate at which one currency can be
exchanged for another.
e.g. Rs. 59.50 per one USD

Major currencies of the World

USD
EURO
YEN
POUND STERLING
What is a Foreign Exchange Transaction ?
 Any financial transaction that involves more than one
currency is a foreign exchange transaction.
 Most important characteristic of a foreign exchange
transaction is that it involves Foreign Exchange Risk.
PARTICIPANTS IN THE FOREIGN
EXCHANGE MARKET
 All Commercial Banks
(Authorized Dealers only).
 State Bank of Pakistan.
 Corporate Treasuries.
 Public Sector/Government.
 Inter Bank Brokerage Houses.
 Resident Pakistanis
 Non Residents
 Exchange Companies
 Money Changers
 FOREIGN EXCHANGE REGIMES

 FIXED
 PEGGED
 COMPOSITE
 MANAGED FLOAT
 FREE FLOATING
 Components of a Standard
FX Transaction
 Base Currency (USD/PKR)
 ‘Dealt’ or ‘Variable’ Currency
 Exchange Rate
 Amount
 Deal Date
 Value Date
 Settlement Instructions
 Value Date Conventions
Currencies are traded both in Ready and forward
value dates.

1) Ready: Settlement on the deal date. e.g. Pakistan

2) Value Tom : Settlement on next day. e.g. Canada
3) Spot Transaction : settlement usually in two working days.
In international FX transactions, Spot is the Standard value
date.
Why Spot Date ?

 Time Zone Difference

 Herstat Risk
4) Forward Transaction: Settlement at some future date ahead
of the spot. 12
FX Rate Quotation:
In the forex market rates are always quoted ‘two way’.
Two way quote gives both ‘Bid’ and ‘Offer’.
e.g.
USD/PKR= 58.55 / 60
Bid / Offer
‘Big Figure’: Term referring to the first digits of an exchange rate. These figures are rarely change in
normal market fluctuations and are usually omitted in dealer quotes.

‘Pips (or Point): The smallest incremental move an exchange rate can make.

‘Base Currency’ Vs. ‘Dealt Currency’

Number of variable or dealt currency unit in one unit of base currency.

In international quotes base currency comes first.
e.g. BC/VC
USD/PKR= 58.55/60
 Price maker Vs. Price Taker

The bank quoting the price is ‘price maker’ or

‘market maker’.

The bank asking for the price or ‘quote’ is the

‘price taker’ or ‘user’.
 RATE QUOTATION CONVENTIONS
IN-DIRECT QUOTATION:
“Price of one Unit of Foreign Currency in terms of
Domestic Currency”
e.g. USD/PKR = 59.45/50
Buy One USD at 59.45
Sell One USD at 59.50
Spread 00.05
In the international market, almost all currencies
are quoted indirectly.

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 RATE QUOTATION CONVENTIONS
DIRECT QUOTATION:
“Price of one Unit of Domestic Currency in terms of Foreign Currency”
e.g. EURO= 1.2805/12
Buy One Euro at 1.2805
Sell One Euro at 1.2812
Spread 0.0007

Five Currencies are quoted in Direct Terms

1) Pound Sterling
2) Euro
3) Australian Dollar
4) New Zealand Dollar
5) Irish Punt

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 In the international market, almost all the
currencies are quoted in terms of USD.
e.g.
JPY= 105.78/82
A visit to REUTERS ‘EFX=’ Page.
 FORWARD TRANSACTIONS

1. Out right sale/purchase of a currency against the other

for settlement at a future date at the predetermined
exchange rate.
2. Forward rates are quoted as premium or discount over
spot rate.

3. Forward rates depend upon interest rate differential

between the two currencies.

4. Currency with higher interest rates is at discount wrt

currency having lower interest rate.

5. Currency with lower interest rates is at premium wrt

currency having higher interest rate.
 Calculating Forward Rate

Interest rate of USD = 1.25%

Interest rate of PKR = 6%
Spot Rate = 58.50
DB for PKR = Actual/365
DB for USD = Actual/360

Six month Forward Rate =

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

“An FX swap is a contract to buy an amount of

currency for one value date at an agreed rate,
and to simultaneously resell the same amount of
currency for a later value date, also at an agreed
rate, to the same counter party”.

FX swap is essentially a ‘funding’ or ‘Money

Market’ transaction and does not involve
exchange risk.
 Foreign exchange transactions are settled through Nostro and
Vostro accounts.

 Nostro: our account with banks abroad. SBP maintains

various Nostro accounts in a number of countries.
 Vostro: their account with us. Many multilateral agencies
(e.g. IMF, World Bank) maintain their Nostro accounts at
SBP.

 SWIFT (Society for Worldwide Interbank Financial

Telecommunications)
Deals are done over Telephone, REUTERS
dealing system etc
REUTERS
Dealing Terminal
 Industry Standard for FX trading.
 Security guaranteed by Reuters Int.
 Password Protected.
 Maintains record of all transactions.
 SBPK (SBP’s REUTERS address)

News Terminal
 Domestic Market Data/ news available on line.
 Real Time Exchange Rate quotes of all major Currencies.
 Data about Interest Rates (e.g. LIBOR)
 Various SBP pages on REUTERS.
Pre-Reform era till early 90s ( The fixed ERM &
Exchange Control Regime)
 Fixed ERM, with occasional devaluations.
 SBP to fix its buying & selling rates for Authorized Dealers
and their rates for customers.
 Residents not allowed to hold foreign exchange.

 Only ADs (Banks), allowed to deal in Fx.

 Fx available only for current account transactions. (goods &

services) and some other personal transactions viz. travel,
education, medical treatment etc.
 Pre-Reform era till early 90s
(The fixed ERM & Exchange Control Regime)
 SBP to buy and sell forex from and to ADs, at its
buying and selling rates for Authorized Dealers.
 SBP to provide forward cover to ADs for importers
and exporters as well as foreign currency loans
mobilized by corporates from abroad.
 Exporters of goods and services, were bound to sell
forex to an AD at rates prescribed by SBP.
 Elaborate system of reporting by ADs to SBP.
Market liberalization. The decade of 90s

 Early nineties marked an era of liberalization of foreign

exchange market.
 FCAs Scheme was launched for Resident Pakistanis.
Banks were required to surrender their FC deposits
against purchase of forward cover from SBP.
 Money Changers were authorized to Deal in foreign
exchange (Notes and TCs only).
 Forward cover for imports and exports shifted to banks.
 Forward cover for FC loans also transferred to banks
(under certain rules and regulations).
Post detonation crisis (May ’98) and move
towards market based ERM.
 In early 98, Pakistan was making gradual moves
towards market based ERM.
 Third currency rates to be quoted by banks.

 SBP also stopped giving customer’s buying

and selling rate and gave a 1% band to the
market, quoting its buying and selling rates for
ADs.
 The target was to put the currency on free float.
Post detonation crisis (May ’98) and move
towards market based ERM.
 Detonation of May 98 changed the way things were
moving.
 Despite low reserves, SBP made the decision of going
ahead with fx market reforms.
 Phased approach was adopted for transition to free float.
 As a first step Two-Tier ERM was introduced in July 21,
1998.
 Except for essential items (e.g. wheat l/cs) , the rest of
the trade transactions were settled through interbank
market.
 Initially 50/50 , 80/20, FINALLY 95/05
Post detonation crisis (May ’98) and
move towards market based ERM.
 Two-tier was finally abolished in May 1999.
 Currency was freely floated.
 Regulations pertaining to current account
transactions remained more or less unchanged.
However all transactions were to be done at
interbank rate and every bank was to offer its own
rate to customers.
 However, an unofficial narrow band was imposed on
banks, which remained there till July 2000. when it
was finally done away with.
 Forex Transactions
The Demand Side of inter-bank market
 importers – buying foreign exchange to finance
their imports.
 A host of regulations governing imports into
Pakistan.
 Out ward remittances for debt servicing.

 Out ward remittances for services.

 PTEQ and BTQ, Medical treatment etc.

 Forex Transactions

The Demand Side of inter-bank market

 Remittances on account of education abroad.

 Remittances on account medical treatment.

 Repatriation of profit of foreign controlled

companies and ‘freight collection’ etc.
 Disinvestment through SCRA.

 A host of other invisible payments.

 Forex Transactions
The Supply Side of inter-bank market
 Exports – regulations governing export receipts.

 Home remittances.

 Foreign Direct Investment.

 Capital account receipts.

 Investment through SCRA.

 A host of other invisible receipts.

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

• NOP is the Net Asset/Net Liability position in all

FCs together (Both B/S & Off B/S).
• Net Asset Position is also called “LONG” or
“Overbought “ position.
• Net liability Position is also called “SHORT” or
“Oversold “ position.
• NOP is a single statistic that provides a fairly good
idea about exchange risk assumed by the bank.
• Its major flaw is that FX exposures in third
currencies remain hidden.
EXAMPLE (NOP) (USD in Mio)

Opening Position $ 0.00

Ready Purchases from Exporter $ 1.00

Fwd Purchases from Corporate (1.00 Euro) \ $ 0.90

Ready Sell to importer ( 60 Mio Yen) - $ 0.50

Fwd Sell to Corporate - $ 0.40

NET OPEN POSITION $

1.00
Introduction to Inter-bank FX activities

Foreign Exchange Exposure

FX Exposure is the higher of the long and short positions in FCs.
EXAMPLE
Currency-wise NOP in equivalent PKR
CURRENCY SHORT LONG
Dollar -10
Yen 10
Euro -10
Pound 10
Total -20 20
Net Open Position is 0 while exposure is 20.
 Foreign Exchange Markets

Role of SBP and linkages with

economy
 SBP’s Role in the Forex Market

 To manage the exchange rate mechanism.

 Regulate inter-bank forex transactions and monitor
the foreign exchange risk of the banks.
 Keep the exchange rate stable.
 Manage and maintain country's foreign exchange
reserves.
SBP’s Role in the Forex Market

• SBP has imposed foreign exchange exposure

limits on banks (FE 12 of 1999).
• The limits are tied with the Paid up capital of
the bank.
• Previously banks had NOP limit, which was
based on foreign exchange volume handled by
the bank.
 TREASURY OPERATIONS AT SBP
1. All Central Banks have treasuries to implement policy
objectives vis a vis EXCHANGE RATE &
INTEREST RATES
2. Dealing room catered to the FX market only
3. Money market was being looked after by the
Securities department
4. It soon became apparent that the two cannot work in
isolation with each other as the linkage between the
money market & exchange market became
pronounced
5. Finally the dealing room and securities department
were merged to form EDMD to from first ever
Treasury of SBP.
 Functions of DMMD
Market Monitoring
 Pro active monitoring of interbank MM & FX
market by Front Office.
 Prepare demand/supply forecast.

 Gather data from various Sources.

 Real time feedbck to management.

 Real time remedial measures to remove

distortions in the market.
 A day in the Front Office
 NOP report.
 FX inflow/outflow statements.
 Oil payments,
 Forward transactions.
 Market monitoring – Market Flows and their impact
on exchange rate.
 Money Market liquidity
 Forward rates
 Market activity – if required
 Rates Preparation – M 2 M, Wtd Avg, FCA
Conversion.
 Front Office Challenges
 Small Market Size
 Lumpy payments

 ‘Leads’ and ‘Lags’.

 Historical trend of keeping long positions.

 The issue of ‘entries in transit’.

 INTERVENTION
 To keep exchange rate in line with macro
objectives SBP has to intervene from time
to time
 Intervention is a process where FX is sold
or purchased to keep the right amount of
liquidity available in the FX market so that
demand / supply equilibrium is maintained
 Intervention can be in READY or
FORWARD
OTHER FX RELATED FUNCTIONS

 OFFSITE MONITORING
 DAILY RATES FOR MARKET
 THIRD CURRENCY ACTIVITY FOR GoP
PAYMENTS
 RESERVE MANAGEMENT
Off Site monitoring of banks by SBP

Inputs of Computerized
Reporting System (CRS)

All individual foreign exchange transactions reported by

each bank on daily basis on a floppy diskette

Amount Currency Posting date

Counter Party Rate Deal Date
Type of Deal Maturity Date Mode of Deal
Off Site monitoring of banks by SBP

Reports from CRS

Exposure Report
FE - 25 balances & other deposits
Nostro Balances
Un-reconciled interbank deals
Off Site monitoring of banks by SBP

Reports from CRS Cont’d

Reports for research & statistical purposes

Types of transactions/customers/currency
Business volume - banks/customers/currency
Broker wise market volume report
History of exchange rates - trend analysis
How does SBP manages exchange
rate in the interbank market?

• Non-Quantitative Tools
• Quantitative Tools
Non-Quantitative Tools

• Moral suasion
• facilitating large commercial outflows
• Relaxation in FEEL
 How does SBP manages exchange
rate in the interbank market?
Quantitative Measures
Foreign Exchange Exposure Limit (FEEL)
 Basically restricts the banks to keep a net asset (long) or net
liability (short) position in foreign currencies.
 Presently FEEL for each bank is set at 15 % of it’s paid up
capital.
 In the presence of FEEL, banks’ net purchases or net sales in
foreign exchange on a given day have to be within their
FEEL.
Physical intervention
• Direct selling or buying of foreign exchange by State
Bank in the interbank market.
• Such sale/purchase can be in spot or forward value
• It can have two objectives
To provide support to the market for
lumpy payments
To manage the Rs/$ parity

• Intervention may be direct or indirect. Currently SBP

only indirectly intervenes in the market.

• RESERVE BUILDING
Thank
Thank You
You