MERCHANT RATES AND INTER BANK TRANSACTIONS

Introduction
Foreign exchange transactions in the foreign exchange market can be broadly divided into two: 1. Merchant transactions and 2. Inter bank transactions. While the dealing of a bank with its customer is known as merchant business or merchant transactions and the rates quoted in such transactions are called merchant rates, the foreign exchange transaction between banks are known as inter bank transactions and the rates quoted in such transactions are known as inter bank rates. When a merchant transaction takes place? The exporter in order to convert his sale proceeds received in the form of foreign currency into domestic currency approaches the banker of his country. Similarly, the importer approaches his banker in his country to convert the domestic currency into foreign currency. Such transaction also takes place when a resident approaches his bank to convert foreign currency received by him into home currency and vice versa. In the both the deals the banks book a profit. These explain the existence of a distinct relationship between merchant rates and inter bank rates. The prevailing inter bank rate becomes the basis for merchant rates. The merchant business in which the contract with the customer to buy or sell foreign exchange is agreed to and executed on the same day is known as ready transaction or cash transaction. As in the case of inter bank transactions, a value next day contract is deliverable on the next business day and a spot contract is deliverable on the second succeeding business day f ollowing the date of the contract. Most of the transactions with customers are on ready basis. In practice, the terms ready and spot are used synonymously to refer to transactions concluded and executed on the same day.

Basis for Merchant Rates

When the bank buys foreign exchange for the customer, it sells the same in the inter bank market at better rates and thus makes a profit out of the deal. In the inter bank market, the bank will accept the rate as dictated by the market. It can therefore sell foreign exchange in the market at the market buying rate for the currency concerned. Thus the inter bank buying rate forms the basis for quotation of buying rate by the bank to its customer. In the same manner, when the bank sells foreign exchange to the customer, it meets the commitment by purchasing the required foreign exchange from the inter bank market. It can acquire foreign exchange from the market at the market selling rate. Therefore, the inter bank selling rate forms the basis for quotation of selling rate to the customer by the bank. The inter bank rate on the basis of which the bank quotes its merchant rate is known as base rate. Exchange Margin: When a merchant customer approaches his banker for foreign exchange and if the bank quotes the base rate to the customer, it makes no profit. On the other hand, there are administrative costs involved in the transaction. Moreover, the deal with the customer takes place first and only after acquiring or selling the foreign exchange from/to the customer, the bank goes to the inter bank market to sell or acquire the foreign exchange required to cover the deal with the customer. Between these transactions there will be time gap of say an hour or two and the exchange rates

are fluctuating constantly and by the time the deal with the market is concluded, the exchange rate might have turned adverse to the bank. Under such circumstances, to cover the administrative cost, to overcome the exchange fluctuation and gain some profit on the transaction to the bank sufficient margin need to be built into the rate. This is done by loading exchange margin to the base rate. The quantum of margin that is built into the rate is determined by the bank concerned, keeping with the market trend. FEDAI has standardized the exchange margin to be charged by the banks and the banks are free to load margins within the range. The FEDAI fixed margins are: 1. 2. 3. 4. TT Purchase rate 0.025% to 0.080% Bills Purchase rate 0.125% to 0.150% TT Selling rate 0.125% to 0.150% Bills selling rate 0.175% to 0.200% (Over TT selling rate)

Fineness of Quotation: The exchange rate is quoted upto 4 decimals in multiples of 0.0025. The quotation is for one unit of foreign currency except in the case of Japanese Yen, Belgian Franc, Italian Lira, Indonesian Rupiah, Kenyan Shilling, Spanish Peseta and currencies of Asian Clearing Union countries (Bangladesh Taka, Myanmar Kyat, Iranian Riyal, Pakistani Rupee and Sri Lankan Rupee) where the quotation is per 100 units of the foreign currency concerned. Examples of valid quotations are:

USD 1 = Rs. 43.2350 GBP 1 = Rs. 63.3525 EUR 1 = Rs. 43.5000 JPY 100 = Rs. 35.6075 While computing the merchant rates, the calculations can be made upto five places of decimal and finally rounded off to the nearest multiple of 0.0025. For example, if rate for US dollar works out to Rs. 43.12446 per dollar, it can be rounded off to Rs. 43.1250. The rupee amount paid to or received from a customer on account of exchange transaction should be rounded off to the nearest rupee, i.e., up to 49 paise should be ignored and 50 to 99 paise should be rounded off to higher rupee (Rule 7 of FEDAI).

DIFFERENT MODES OF FOREIGN EXCHANGE REMITTANCES

The flow of foreign exchange may take the form either moving into the country as a result of purchase transaction or moving out of the country as a result of a sale transaction. Either case the remittances could take place through various forms. The different forms of remittances are ; 1. 2. 3. 4. Demand draft Mail transfer Telegraphic transfer and Personal cheques.

Types of Buying Rates In a purchase transaction the bank acquires foreign exchange from the customer and pays him in Indian rupees. Under such circumstances, while some of the purchase transactions result in the bank acquiring foreign exchange immediately, some may take time in the acquisition of foreign

exchange. Say for instance, if the bank pays a demand draft drawn on it by its correspondent bank, there is no delay because the foreign correspondent bank would already have credit the nostro account of the paying bank while issuing the demand draft. On the other hand, if the bank purchases an On demand bill from the customer, it has first to be sent to the drawees place for collection. The bill will be sent to the correspondent bank for collection. The correspondent bank will present the bill to the drawee. The nostro account of the bank with its correspondent bank is credited only when the drawee makes payment against the bill. Suppose this takes 20 days. The bank will acquire foreign exchange only after 20 days. Based on the time of realization of foreign exchange by the bank, the bank quotes two types of buying rates: 1. 2. TT Buying Rate, and Bill Buying Rate.

TT Buying Rate (TT stands for Telegraphic Transfer) When there is no delay involved in the realization of foreign exchange by the bank then the rate applicable in such a transaction is TT Buying rate. In other words, the banks account with the overseas bank account of the bank would already have been credited with. In order to arrive at the TT buying rate, the exchange margin is deducted from the inter bank buying rate. Though the name implies telegraphic transfer, it is not necessary that the proceeds of the transaction are received by telegram. Any transaction where no delay is involved in the bank acquiring the foreign exchange will be done at the TT rate. Transactions where TT rate is applied are: 1. 2. 3. Payment of demand drafts, mail transfers, telegraphic transfers, etc. drawn on the bank where banks nostro account is already credited; Foreign bills collected. When a foreign bill is taken for collection, the bank pays the exporter only when the importer pays for the bill and the banks nostro account abroad is credited; Cancellation of foreign exchange sold earlier. For instance, the purchaser of a bank draft drawn on New York may later request the bank to cancel the draft and refund the money to him. In such case, the bank will apply the TT buying rate to determine the rupee amount payable to the customer.

The method of calculating TT buying rate for foreign exchange to be purchased for US dollars is given below. TT Buying Rate Dollar / Rupee market spot buying rate = Rs. Less: Exchange margin -- Rs. TT Buying rate = Rs. .. Rounded off to nearest multiple of 0.0025. Bill Buying Rate When foreign bill is purchased then the rate applicable would be bill buying rate. Under this, when a bill is purchased, the proceeds will be realized by the bank after the bill is presented to the drawee at the overseas center. In the case of a usance bill the proceeds will be realized on the due date of the bill which includes the transit period and the usance period of the bill. Let us suppose that a sight bill on London is purchased; the realization will be after a period of about 20 days (transit period) and the bank would be able to dispose of the foreign exchange only

after this period. Therefore, the rate quoted to the customer would be based not on the spot rate in the inter bank market, but on the inter bank rate for 20 days forward. Similarly, if the bill purchased is 30 days usance bill, then the bill will realize after about 50 days (20 days transit plus 30 days usance bill, period). Therefore, the bank would be able to dispose of foreign exchange only after 50 days; the rate to the customer would be based on the inter bank rate for 50 days forward. It is important in this that while loading the bills buying rate with forward margin two points need to be taken into account. First, forward margin is normally available for periods of a calendar month and not for 20 days etc. Secondly, forward margin may be at a premium or discount. Premium is to be added to the spot rate and discount should be deducted from it. Since the banks aim is to book profit, while making calculations, the bank will see that the period for which forward margin is loaded is beneficial to the bank. Let us suppose that on 23rd January inter bank quotation for US dollar was as under: Spot Spot/January Spot /February /March USD 1 =Rs. 43.5000/5500 2000/2100 5000/5100 7500/7600

The bank wants to calculate bill buying rate for a sight bill. The transit period is, say 20 days. The bill will fall due on 12th February. Apparently, the forward rate relevant is spot/February rate as this is valid for the entire month of February. However, it should be noted that forward dollar is at premium. The customer will be getting more rupees per dollar under the forward rate than under the spot rate. As we have already seen, the forward premium represents the interest differential. The Spot/February forward premium includes interest differential up to the last day of February. As this benefit does not fully accrue on 12th February, when the bill is expected to mature, the bank will not concede premium up to this month. It will concede premium only up to the last completed month and base its bill buying rate for dollar on the Spot/January forward rate. [If the bank takes Spot/February forward premium, the base rate will be Rs.44.0000. By taking only Spot/January premium, the bank offers only Rs. 43, 7000 per dollar, which is beneficial to the bank.] In case of a 30 days usance bill submitted on the same date, the expected due date (called the notional due date) is 14th March. The bank will concede premium only up to February. Thus, where the foreign currency is at premium, while calculating the bill buying rate, the bank will round off the transit and usance periods to lower month. Let us assume that on 18th April, the dollar is at discount and the quotation in the inter bank market is as under: Spot Spot/April /May /June USD 1 = Rs. 42.7500/8000 1300/1200 3000/2900 5500/5400

Let us consider an example that the bank is required to quote a rate for purchasing a sight bill on New York. Transit period is 20 days. The bill will fall due on 8th May. Since dollar is at discount, forward dollar fetches lesser rupees than spot dollars. In other words, longer the forward period involved, the bank is able to get dollar from the customer at cheaper rate. Therefore, the bank will

deduct discount up to May end while quoting for this bill. In case of a usance bill for 30 days, the due date falls on 7th June. The bank will base its rate to the customer on Spot/June forward rate. Here, the due date of the bill is rounded off to the higher month, i.e., end of the month in which it falls. Thus, where the foreign currency is at discount, while calculating the bill buying rate, the bank will round off the transit and usance periods to higher month. It is important to keep in mind the rule for loading forward margin in the bill buying rate : For calculating bill buying rate, if the forward margin is at premium round off the transit period and usance period to lower month; if the forward margin is at discount round off the forward margin to the higher month. In the TT buying rate, the bank would include exchange margin in the rate quoted to the customer while quoting for purchase of bills also. The margin may be slightly higher than that for TT buying rate. It should have been observed that there will be more than one bill rate, each for a different period of usance of the bill. The method of calculating bill buying rate is as follows:

Bill Buying Rate

Dollar/Rupee market spot buying rate = Rs. Add : Forward premium (For transit and usance; rounded off to lower month) OR Less : Forward discount (For transit and usance : rounded off to higher month) Rs. .. = Rs. .. Less: Exchange margin - Rs. .. Bill buying rate = Rs. .. Rounded off to the nearest multiple of 0.0025

Recovery of Interest on Bills Purchased

When the bank buys a bill from the customer, it immediately pays him in Indian rupees. The bank is entitled to claim interest from the customer from the date of purchase of the bill till the bill realized and credited to the nostro account of the bank with correspondent bank abroad. On the rupee value of the bill purchased, on the date of purchase itself, the bank should collect separately, by debit to customers account, the interest on the bill up to its anticipated due date (called the notional due date) comprising: 1. 2. 3. the normal transit period; the usance of the bill; and the grace period, if applicable at the place where the bill is drawn payable.

The normal transit period is the period of transit allowed by FEDAI for bills drawn on different countries. The rate of interest to be collected will be determined by the bank concerned subject to the directives of Reserve Bank in this regard. Interest shall also be rounded off to the nearest rupee. (Rate value of bill x Rate of Interest x Number of days ) / 100 x 365

For the bill in Example assuming an interest rate of 10% p.a., the interest recovered on purchase of the bill would be as follows: (4298,750 x 10 x 20 ) / 100 x 365 = Rs. 23,555 Types of Selling Rates: In a sale transaction when the bank sells foreign exchange and it actually receives Indian rupees from the customer and parts with foreign currency. The sale is effected by issuing a payment instrument on the correspondent bank with which it maintains the nostro account. Immediately on sale, the bank buys the requisite foreign exchange from the market and gets its nostro account credited with the amount so that when the payment instrument issued by it is presented to the correspondent bank it can be honoured by debit to the nostro account. Therefore for all sales on ready/spot basis to the customer, the bank resorts to the inter bank market immediately and the base rate is the inter bank spot selling rate. However, depending upon whether the sale involves handling of documents by the bank or not, two types of selling rates are quoted in India. They are: 1. 2. TT selling rate; and Bills selling rate.

TT Selling Rate This is the rate applicable for all transactions which do not involve handling of documents by the Transactions for which this rate is quoted are: 1. 2. 3. Issue of demand drafts, mail transfers, telegraphic transfers, etc., other than for retirement of an import bill; and Payment made for an import transaction where documents were received directly by the importer; Cancellation of a purchase transaction.

The TT selling rate to the customer is calculated on the basis of inter bank selling rate by adding exchange margin to the inter bank rate. Bills Selling Rate This rate is to be used for all transactions which involve handling of documents by the bank: for example, payment against import bills. This bills selling rate is calculated by adding exchange margin to the TT selling rate. That means the exchange margin enters into the bills selling rate twice, once on the inter bank rate and again on the TT selling rate. The method of calculating selling rate is given below:

Some aspects of exchange quotation Spread Between TT Rates:

While making exchange quotations the banks have the discretion to include the exchange margin at rates determined by them. However, that the maximum spread between TT buying and TT selling rates quoted to the customers shall be as follows:

The banks are; however, free to quote to customers which are better than those warranted by the spread limits. Let us call the currency (other than US dollar) for which the exchange rate is calculated Calculation of ready rates as the foreign currency. Suppose a customer tenders a foreign current bill for purchase by the bank. In the case of a foreign currency being tendered by the customer bank should first get foreign currency converted to US dollar in the international market. In other words, it has to buy dollars in the international market against foreign currency. The bank can do so at the market selling rate for dollar. Therefore the merchant rate for the foreign currency would be calculated by crossing the dollar selling rate against the foreign currency in the international market and dollar buying rate against rupee in the inter bank market. The method of calculating ready rates thus is tabulated below.

Selling Rates When the bank sells foreign exchange (other than dollar) to the customer, it has acquired the required foreign currency in the international market by selling equivalent US dollars. The bank can sell US dollars in the international mark the market buying rate for US dollars against the foreign currency concerned dollars required to effect this sale have to be acquired in the inter bank mark the market selling rate. Therefore, in calculating the merchant selling rate foreign currency the

relevant rates are dollar buying rate against the foreign currency concerned in the international market and dollar selling rate against rupees the inter bank market.

FORWARD EXCHANGE CONTRACT

In the previous chapter, we have already discussed the forward exchange rate and the context in which it arises etc. Here our interest is to understand how the forward exchange rate is entered into and the problems associated with it. A forward exchange contract is a mechanism by which one can ensure the value of one currency against another by fixing the rate of exchange in advance for a transaction expected to take place at a future date. It is a tool to protect the exporters and importers against exchange risks. The uncertainty about the rate which would prevail on a future date is known as exchange risk. From the point of an exporter the exchange risk is that the foreign currency in which the transaction takes place may depreciate in future and thus the expected realization will be less in terms of local currency. The importer also faces exchange risks when the transaction is designated in a foreign currency. In this case the foreign currency may appreciate and the importer may be compelled to pay an amount more than that was originally agreed upon in terms of domestic currency. In the case of forward exchange contract two parties, one being a banker from one country entering to a contract to buy or sell a fixed amount of foreign currency on a specified future date or future period at a predetermined rate. The forward exchange contracts are entered into between a banker and customer or between two parties.

FEATURES OF FORWARD EXCHANGE CONTRACT

The following are the features of a forward exchange contract. FEDAI has also laid down certain guidelines defining certain aspects of forward exchange contract.

Parties: There are two parties in a forward exchange contract. They can be, 1. A bank and a customer. 2. Two banks in the same country. 3. Two banks in different countries. Amount: forward exchange contracts are entered into for a definite sum expressed in foreign currency. Rate: the rate at which the conversation of foreign exchange is to take place at a future date is agreed upon at the time of signing the forward contract which is known as the contracted rate and is to be mentioned in the contract. Date of Delivery: Date of delivery in a forward contract means the future date on which the delivery of foreign exchange is to take place and is computed from the spot date or date of contract. However in practice, date of delivery is computed from the spot date and hence if a forward contract is signed on 30th Oct with spot date as Nov, 2005 for 2months forward. The date of delivery is Jan 1, 2006. In India Rule7, FEDAI has laid down certain guidelines regarding date of delivery under forward contract. In the case of bills/documents negotiated, purchased or discounted-date of negotiation, purchase or discount and payment of rupees to customer. In the case of bills/documents sent for collection, date of payment of rupees to the customer on realization of bills. In case of retirement /crystallization of import bills/documents-the date of retirement /crystallization of liability whichever is earlier. Option period: in India FEDAI under Rule 7 has laid down guidelines for option period. The option period of delivery in an option forward contract should be specified as a calendar week that is 1st to 7th, 8th to 15th, 16th to 23rd or 24th to last working day of the month or a calendar fortnight that is 15th or 16th to last working day the month. If the fixed date of delivery or the last date in an option forward contract happens to be a holiday, the delivery shall be effected/delivery option exercised on the preceding working day. Option of delivery: In all option forward contracts the merchant whether a buyer or a seller will have the option of delivery.

Place of delivery: All contracts shall be understood to read to be delivered or paid for at the bank and at the named place. That is, the contractual obligations under a forward exchange contract like delivery of foreign exchange or payment are to be executed at the specified branch of the bank.

FEDAI GUIDELINES FOR FORWARD CONTRACTS: RULE NO 7

Exchange contracts shall be for definite amount. Unless date of delivery is fixed and indicated in the contract the option period of delivery should be specified as calendar week or calendar fortnight or calendar month. If the fixed date of delivery or last date of delivery option is a holiday, the delivery has to be effected on the preceding working day. Place of delivery is always at the Bank and at the named place. Option of delivery is always that of the merchant. The minimum commission is Rs 250 for booking a forward contract. Minimum charge is Rs 100 for every request of early delivery extension/cancellation. Fixed and Option Forward Contracts Under the fixed forward contract the delivery of foreign exchange should take place on a specified future date. Then it is known as fixed forward contract. Suppose a customer enters into a three months forward contract on 5th January with his bank to sell Euro 15,000, then the customer would be presenting a bill or any other instrument on 7th April to the bank for Euro 15,000. The delivery of foreign exchange cannot take place prior to or later than the determined date. Though forward exchange is a mechanism wherein the customer tries to over come the exchange risk, the purpose will be defeated if the delivery of foreign exchange does not take place exactly on the due date. Practically speaking, it is not possible for any exporter to determine in advance the precise date on which he will be tendering export documents for reasons which are internal relating to production. Besides internal factors relating to production many other external factors also decide the date on which he is able to complete shipment and present documents to the bank. More often, what is possible for the exporter is only estimate the probable date around which he would be able to complete his commitment. Under such circumstances, just to avoid the difficulty of fixing the exact date for delivery of foreign exchange, the customer may be given a choice of delivering the foreign exchange, during a given period of days. Such an arrangement whereby the customer can sell or buy from the bank foreign exchange on any day during a given period of time at a predetermined rate of exchange is known as Option Forward Contract. The rate at which the deal takes place is the option forward rate. For example, on 10th June a customer enters into two months forward sale contract with the bank with option over August. It means the customer can sell foreign exchange to the bank on any day between 1st August and 31st August In the example, the period during which the transaction takes place is known as the Option Period. Computation of Forward Exchange Rates Fixed Forward Contracts:

The method of calculation of forward rates is similar to that of ready rates discussed earlier. However, in the case of forward rates, the forward margin added will include the forward period as well besides the transit and usance period. While selling the forward margin is included only for the forward period. Calculation of Option Forward Rates

In the case of option forward contract the customer has the freedom to deliver the foreign exchange on any day during the option period. The bank should quote a single rate valid for the entire option period. The option rate quoted on behalf of the customer is based on the inter bank option forward rate, while between banks the option of delivery under a forward contract rests with the buying bank. To put it simply, the quotation under option delivery is as follows: for purchase transactions quote premium for the earliest delivery and for sale transactions quote premium for latest delivery. Execution of Forward Contract A customer under forward contract knows in advance the time and amount of foreign exchange to be delivered and the customer is bound by this agreement. There should not be any variation and on the due date of the forward contract the customer will either deliver or take delivery of the fixed sum of foreign exchange agreed upon. But, in practice, quite often the delivery under a forward contract may take place before or after the due date, or delivery of foreign exchange may not take place at all. The bank generally agrees to these variations provided the customer agrees to bear the loss, if any, that the bank may have to sustain on account of the variation. Though the delivery or take delivery of a fixed sum of foreign exchange under a forward contract has to take place at the agreed time, quite often this does not happen and it may either take place before or after the due date agreed upon. However, the bank generally agrees to these variations provided the customer bears the loss if any on account of this variation. Based on the circumstances, the customer may end up in any of the following ways: 1. 2. 3. 4. 5. 6. 7. 8. 9. Delivery on the due date. Early delivery. Late delivery. Cancellation on the due date. Early cancellation. Late cancellation. Extension on the due date. Early extension. Late extension.

As per the Rule 8 of FEDAI, a request for delivery or cancellation or extension of the forward contract should be made by the customer on or before its maturity date. Otherwise a forward contract which remains unutilized after the due date becomes an overdue contract. Rule 8 of FEDAI stipulates that banks shall levy a minimum charge of Rs. 100 for every request from a merchant for early delivery, extension or cancellation of a forward contract. This is in addition to recovery of actual loss incurred by the bank caused by these changes. Delivery on Due Date This is the situation envisaged when the forward contract was entered into. When the foreign exchange is delivered on the due date, the rate applied for the transaction would be the rate originally agreed, irrespective of the spot rate prevailing. Early Delivery

When a customer requests early delivery of a forward contract, i.e., delivery before its due date, the bank may accede to the request provided the customer agrees to bear the loss, if any, that may accrue to the bank. The various operations involved may be summarized thus:

On 1st May, the bank makes a spot purchase and forward sale of the same Currency for the same value. The difference between the rate at which the currency is purchased and sold in a swap deal is the swap difference. The swap difference may be a swap loss or swap gain depending upon the rates prevailing in the market. If the bank buys high and sells low, the differences Swap loss recoverable from the customer. It the bank buys low and sells high, the difference is the swap gain payable to the customer. On 1st May, the bank receives rupees from the customer on sale of foreign exchange to him. It pays rupees to the market for the spot purchase made. If the amount paid exceeds the amount received, the difference represents outlay of funds. Interest on outlay of funds is recoverable from the customer from the date of early delivery to the original due date at a rate not lower than the prime lending rate of the bank concerned. If the amount received exceeds the amount paid, the difference represents inflow of funds. At its discretion, the bank may pay interest to the customer of inflow of funds at the appropriate rate applicable for term deposits for the period for which the funds remained with it. Charges for early delivery will comprise of: 1. 2. 3. Swap difference; Interest on outlay of funds; and Flat charge (or handling charge) Rs. 100 (minimum).

Important Note: In the deal with its customer the bank is the market maker and the transaction is talked of as purchase or sale from the banks point of view. When the bank deals with the market, it is assumed that the market is the mark maker. Therefore, the market rates are interpreted with the market buying selling the foreign exchange. The bank can buy at the market selling rate and sell at the market buying rate. Cancellation/Extension of forward contract The customer is having the right to cancel a forward contract at any time during the currency of the contract. The cancellation is governed by Rule 8 of the FEDAI. The difference between the

contracted rate and the rate at which the cancellation is done shall be recovered or paid to the customer, if the cancellation is at the request of the customer. Exchange difference not exceeding Rs.50 shall be ignored. The spot rate is to be applied for cancellation of the forward contract on due date. The forward rate is to be applied for cancellation before due date. In the absence of any instruction from the customer, contracts which have matured shall on the 15th day from the date of maturity be automatically cancelled. If the 15th day falls on a holiday or Saturday the cancellation will be done on the next succeeding working day. The customer is liable for recovery of cancellation charges and in no case the gain is passed on to the customer since the cancellation is done on account of customers default. The customer may approach the bank for cancellation when the underlying transaction becomes infractions, or for any other reason he wishes not to execute the forward contract. If the underlying transaction is likely to take place on a day subsequent to the maturity of the forward contract already booked, he may seek extension in the due date of the contract. Such requests for cancellations or extension can be made by the customer on or before the maturity of the forward contract. Cancellation of Forward Contract on Due date When a forward purchase contract is cancelled on the due date it is taken that the bank purchases at the rate originally agreed and sells the same back to the customer at the ready TT rate. The difference between these two rates is recovered from/paid to the customer. If the purchase rate under the original forward contract is higher than the ready T.T selling rate the difference is payable to the customer. If it is lower, the difference is recoverable from the customer. The amounts involved in purchase and sale of foreign currency are not passed through the customers account. Only the difference is recovered/paid by way of debit/credit to the customers account. In the same way when a forward sale contract is cancelled it is treated as if the bank sells at the rate originally agreed and buys back at the ready T.T buying rate. The difference between these two rates is recovered from/paid to the customer. Example: A forward sale contract for French francs 2,50,000 for an import customer on 15th March for delivery on 15th April at Rs.7.0450. The customer requests for cancellation of the contract on the due date. The following information are available. French francs were quoted in London foreign exchange market as under. Spot 1 month 2 months USD 1 = FRF 6.0200/0300 305/325 710/760

The U.S dollars were quoted in the local inter bank exchange market on the date of cancellation is as follows. Spot Spot/May Spot/June USD 1 = Rs. 42.2900/2975 3000/3100 6000/6100

Exchange margin required is 0.10%. What will be the cancellation charges payable by the

customer? Solution: The sale contract will be cancelled at the ready T.T buying rate.

Dollars/rupee market buying rate Less exchange margin at 0.10%

= Rs. 42.2900 = Re 0.0423 Rs.42.2477

Dollar/Franc markets spot selling rate

= FRF 6.0300

TT buying rate for Franc (42.2477 / 6.0300) = Rs. 7.0062 Rounded off the applicable rate is Rs. 7.0050 Franc sold to customer at = Rs. 7.0450 Now bought from him at Rs. 7.0050 Net amount payable by customer per franc Re 0.0400

Therefore, at Re.0.0400 per franc, the customer has to pay Rs. 10,000 for FRF 2, 50,000 by including flat charge of Rs.100, on cancellation Rs. 10,100 will be recovered from the customer. Early Cancellation of a Forward Contract: Sometimes the request for cancellation of a forward purchase contract may come from a customer before the due date. When such requests come from the customer, it would be cancelled at the forward selling rate prevailing on the date of cancellation, the due date of this sale contract to synchronize with the due date of the original forward purchase contract. On the other hand if a forward sale contract is cancelled earlier than the due date, cancellation would be done at the forward purchase rate prevailing on that day with due date of the original forward sale contract. Extension on Due date An exporter finds that he is not able to export on the due date but expects to do so in about two months. An importer is unable to pay on the due date but is confident of making payment a month later. In both these cases they may approach their bank with whom they have entered into forward contracts to postpone the due date of the contract. Such postponement of the date of delivery under a forward contract is known as the extension of forward contract. The earlier practice was to extend the contract at the original rate quoted to the customer and recover from him charges for extension. The reserve bank has directed that, with effect from16.1.95 when a forward contract is sought to be extended, it shall be cancelled and rebooked for the new delivery period at the prevailing exchange rates. FEDAI has clarified that it would not be necessary to load exchange margins when both the cancellation and re-booking of forwards contracts are undertaken simultaneously. However it is observed that banks do include margin for cancellation and rebooking as in any other case. Further only a flat charge of Rs.100 (minimum) should be recovered and not Rs.250 as in the case of booking a new contract.

Overdue Forward Contracts As we have already seen, the customer has the right to utilize or cancel or extend the forward contract on or before its due date. No such right exists after the expiry of the contract. FEDAI Rule 8 provides that a forward contract which remains overdue with any instructions from the customer concerned on or before its due date shall on the 15th day from the date of maturity be automatically cancelled by the bank. The customer remains liable for the exchange difference arising there from but if it results in profit it need not be passed on to the customer. In case of delivery subsequent to automatic cancellation the appropriate current rate prevailing on such delivery shall be applied. Roll over Forward Contracts When deferred payment transactions of imports/exports takes place, the repayment of the installment and interests on foreign currency loans by the customer requires long term forward cover where the period extends beyond six months. The bank may enter into forward contract for long terms provided there is suitable cover is available in the market. However the cover is made available on roll over basis in which cases the initial contract may be made for a period of six months and subsequently each deferred installments for the outstanding balance of forward contract by extending for further periods of six months each. For these transactions the rules and charges for cancellation / extension of long term forward contracts are similar to those of other forward contracts. Inter bank Deals Foreign exchange transactions involves transaction by a customer with the bank while inter bank deals refer to purchase and sale of foreign exchange between banks. In other words, it refers to the foreign exchange dealings of a bank in inter bank market. Cover Deals The banks deal with foreign exchange on behalf of its customers. Purchase and sale of foreign currency in the market undertaken to acquire or dispose of foreign exchange required or acquired as a consequence of its dealings with its customers is known as the cover deal. In this way that is through cover deal the bank gets insured against any fluctuation in the exchange rates. While quoting a rate to the customer the bank is guided by inter bank rate to which it adds or deducts its margin, and arrives at the rate it quotes to the customer. For example, if its is buying dollar from the customer special it takes inter bank buying rate, deducts its exchange margin and quotes the rate. This exercise is done on the assumption that immediately on purchase from customer the bank would sell the foreign exchange to inter bank market at market buying rate. Foreign currency is considered as peculiar commodity with wide fluctuations price, the bank would like to sell immediately whatever it purchases and whenever it sells, it immediately tries to purchase so that it meets it is commitment. The main reason for this is that the bank wants to reduce exchange risk it faces to the minimum. Otherwise, any adverse change in the rate would affect its profits. In the case of spot deals the transaction is quite simple. If the bank purchased any foreign exchange, it would try to find another customer to whom it can sell this and thus books profit. In this process the profit would be the maximum because both buying and selling rates are

determined by the bank and the margin between the rates is the maximum. If it cannot find another customer its sells in inter bank market where the rate is determined by the market conditions and the margin is narrower here. Example: Your dealer in the Dealing Room sells through an exchange broker in the local market USD 5, 00,000 delivery spot in cover of a telegraphic transfer from abroad.Calculate the rupee amount receivable from this sale assuming that US dollar / Rupees rates are quoted in the local market as under: Spot USD 1 = Rs. 42.8000/8500 Brokerage 0.01% Solution: The bank sells at the market buying rate of Rs. 42.8000.

Rupee amount received on sale of USD 5,00,0000

At Rs. 42.8000 = Rs. 2,14,00,000

Brokerage payable at 0.01% - Rs. 2,140

Net amount receivable on the deal = Rs. 2,13,97,860 Example: A customer sold French Francs 10,00,000 value spot to another customer at Rs. 6.5200 and covered himself in London market on the same day when the exchange rates were as under:

Spot USD 1 = FRF 6.5880/5920

Local inter bank market rates for US dollars were:

Spot USD 1 = Rs. 42.7/8500

Calculate the cover rate and ascertain the profit or loss in the transaction. Ignore brokerage on the inter bank transaction.

Solution: The bank covers itself by buying Francs (or selling dollars) from the London market at market buying rates for dollar. The requisite dollar is acquired in the local inter bank market at the market selling rate for dollar against rupee.

Dollar/Rupee selling rate = Rs. 42.8500

Dollar/Franc buying rate = FRF 6.5880

Franc/Rupee cross rate (42.8500 + 6.5880) = Rs. 6.5042

Franc is sold to customer at Rs. 6.5200

The sale is covered at Rs. 6.5042

Profit per Franc sold =Rs. 0.0158

Profit on FRF 10,00,000 at Re. 0.0158 per Franc = Rs. 15,800.

Note : This rate has not been rounded off because no transaction is done at this rate but is calculated only to arrive at the profit. Trading: Trading refers to purchase and sale of foreign exchange in the market other than to cover banks transactions with the customers. The purpose may be to gain on the expected changes in exchange rates. In India the scope for trading, although still subject to controls, is getting wider the relaxations being made in the exchange control regulations. Example : Your forex dealer had entered into a cross currency deal and had sold USD 5,00,000 against Deutsche Marks at USD 1 = DEM 1.4400 for spot delivery. However, later during the day, the market became volatile and the dealer in compliance with his top managements guidelines had to square up the position by purchasing USD 5, 00,000 against DEM at the on-going rate. Assuming the spot rates are as under: USD 1 = INR 42.4300/4500 and USD 1 = DEM 1.4440/4450 What will be the gain or loss in the transaction? Your answer should be in rupees. Ignore brokerage. Solution: To square its position the bank can purchase US dollars against marks at the market selling rate of DEM 1.4450 per dollar. DEM acquired on sale of USD 5,00,000 at DEM 1.4400 = DEM 7,20,000 DEM paid on purchase of USD 5,00,000 at DEM 1.4450 = DEM 7,22,500 Loss on combined deal in Marks = DEM 2,500 In terms of rupees the loss would be the rupee outlay required to acquire DEM 2,500 from the market. The bank sells USD and acquires DEM at the market USD buying rate of DEM 1.440. The requisite USD it can acquire in the market at the market selling rate of Rs. 42.4500. The Mark/Rupee cross rate is (42.4500 + 1.4440) Rs. 29.3975. Loss on the transaction in rupees = Rs. 23.3975 x 2,500 = Rs. 73.494. Swap Deals:

Swap contracts can be arranged across currencies. Such contracts are known as currency swaps and can help manage both interest rate and exchange rate risk. Many financial institutions count the arranging of swaps, both domestic and foreign currency, as an important line of business. This method is virtually cheaper than covering by way of forward options. Technically, a currency swap is an exchange of debt service obligations denominated in one currency for the service in an agreed upon principal amount of debt denominated in another currency. By swapping their future cash flow obligations, the counterparties are able to replace cash flows denominated in one currency with cash flows in a more desired currency. A swap deal is a transaction in which the bank buys and sells the specified foreign currency simultaneously for different maturities. Thus a swap deal may involve: 1. 2. simultaneous purchase of spot and sale of forward or vice verse ; or Simultaneous purchase and sale, both forward but for different maturities. For instance, the bank may buy one month forward and sell two months forward. Such a deal is known as forward swap.

A swap deal should fulfill the following conditions: There should be simultaneous buying and selling of the same foreign currency of same value for different maturities; and The deal should have been concluded with the distinct understanding between the banks that it is a swap deal. A swap deal is done in the market at a difference from the ordinary deals. In the ordinary deals the following factors enter into the rates: 1. 2. The difference between the buying and selling rates; and The forward margin, i.e.,the premium or discount.

In a swap deal the first factor is ignored and both buying and selling are done at the same rate. Only the forward margin enters into the deal as the swap difference. In a swap deal, both purchase and sale are done with the same bank and they constitute two legs of the same contract. In a swap deal, it does not really matter as to what is spot rate. What is important is the swap difference which determines the quantum of net receipt of payment for the bank as a result of the combined deal. But the spot rate decides the total value in rupees that either of the banks has to deploy till receipt of forward proceeds on the due date. Therefore, it is expected that the spot rate is the spot rate ruling in the market. Normally, the buying or selling rate is taken depending upon whether the spot side is respectively a sale or purchase to the market-maker. The practice is also to take the average of the buying and selling rates. However, it is of little consequence whether the purchase or selling or middle rate is taken as the spot rate. Need for Swap Deals: Some of the cases where swap deal may become necessary are described below: 1. 2. 3. 4. When the bank enters into a forward deal for a large amount with the customer and cannot find a suitable forward cover deal in the market, recourse to swap deal may become necessary. Swap may be needed when early delivery or extension of forward contracts is effected at the request of the customers.Please see chapter on Execution of Forward Contracts and Extension of Forward Contract. Swap may be carried out to adjust cash position in a currency. This explained later in the chapter on Exchange Dealings. Swap may also be carried out when the bank is overbought for certain maturities and oversold for certain other maturities in a currency.

Swap and Deposit/Investment: Let us suppose that the bank sells USD 10,000 three months forward, Instead of covering its position by a forward purchase, the bank may buy from the market spot dollar and kept the amount in deposit with a bank in New York. The deposit will be for a period of three months. On maturity, the deposit will be utilized to meet its forward sale commitment. Such a transaction is known as swap and deposit. The bank may resort to this method if the interest rate at New York is sufficiently higher than that prevailing in the local market. If instead of keeping the amount in deposit with a New York bank, in the above case, the spot dollar purchased is invested in some other securities the transaction is known as swap and investment. Currency Arbitrage Arbitrage traditionally has been defined as the purchase of assets or commodities on one market for immediate resale on another in order to profit from a price discrepancy. In recent years however arbitrage has been used to describe a broader range of activities. The concept of arbitrage is of particular importance in International finance because so many of the relationships between domestic and international financial markets, exchange rates, interest rates and inflation rates depend on arbitrage for their existence. In fact it is the process of arbitrage that ensures market efficiency.

The purchase of currencies on one market for immediate resale on another in order to profit from the exchange rate differential is known as currency arbitrage. If perfect conditions prevail in the market, the exchange rate for a currency should be the same in all centers. Until recently, the pervasive practice among bank dealers was to quote all currencies against the US dollar when trading among them. Now, however, a growing percentage of currency trades dont involve the dollar. For example Swiss banks may quote the Euro against Swiss franc, and German banks may quote pound sterling in terms of Euros. Exchange traders are continually alert to the possibility of taking advantage, through currency arbitrage transactions, of exchange rate inconsistencies in different money centers. These transactions involve buying a currency in one market and selling it in another. Such activities tend to keep exchange rates uniform in the various markets. For example, if US dollar is quoted at Rs. 42.4000 in Mumbai, it should be quoted at the same rate of Rs. 42.4000 at New York. But under imperfect conditions prevailing, the rates in different centers may be different. Thus at New York Indian rupees may be quoted at Rs. 42.4800 per dollar. In such a case, it would be advantageous for a bank in Mumbai to buy US dollars locally and arrange to sell them at New York. Assuming the operation to involve Rs. 10 lakhs, the profit made by the bank would be: At Mumbai US dollars purchased for Rs. 10,00,000 at Rs. 42,4000 would be (10,00,000 42.4000) USD 23,584.90. Amount in rupees realized on selling USD 23,584.90 at New York at Rs. 42.4800 would be Rs. 10,01,887.

Therefore,

the

gross

profit

made

by

the

bank

on

the

transaction

is

Rs,

1,887.

The net profit would be after deducting cable charges, etc., incurred for the transaction. The purchase and sale of a foreign currency in different centers to take advantage of the rate differential is known as arbitrage operations.

When the arbitrage operation involves only two currencies, as in our illustration, it is known as simple or direct arbitrage.

Sometimes the rate differential may involve more than two currencies. For example, let us say that these rates are prevailing:

Mumbai on New York Rs. 42.4000 New York on London USD 1.5100 Mumbai on London Rs. 64.0600 Based on quotation for dollar in Mumbai and for sterling in New York, the sterling rate in Mumbai should be Rs. 64,0250 while the prevailing rate is Rs. 64.0600. The bank can buy dollar locally and utilize it in New York to acquire sterling there. The sterling thus purchased may be disposed of locally. Let us say the transaction in undertaken for Rs. 10,00,000. 1. 2. 3. The bank buys dollars for Rs. 10,00,000 at Mumbai. Amount realized in dollars is (10,00,000 42.4000) USD 23,584.90. The bank sells USD 23,584.90 at New York and acquires pound sterling. Amount realized in pound sterling at USD 1.5100 per pound is (23,584.90 1.5100) GBP 15,619.14. The bank sells GBP 15,619.14 at Bombay at Rs. 64.0600 and realizes Rs. 10,00,562.

Therefore, the gross profit on the combined transaction is Rs. 562. Such an arbitrage operation which involves more than two currencies is known as compound or indirect arbitrage. Currency arbitrage transactions also explain why such profitable opportunities are fleeting. In the process of taking advantage of an arbitrage opportunity the buying and selling of currencies tends to move rates in a manner that eliminates profit opportunity in the future. When profitable arbitrage opportunities disappear, we say that the no arbitrage condition holds.